The Federal Reserve Board, on December 16, 2010, approved proposing a rule to implement the Durbin Amendment in the Dodd-Frank Act.1 The Durbin Amendment requires that the amount of any debit card interchange transaction fee be “reasonable and proportional” to the cost incurred by the issuer with respect to the transaction and requires the Board to establish standards for assessing whether the amount of any such fee is “reasonable and proportional” to costs incurred by the issuer with respect to a given individual transaction.2

By the time the proposed rules were published, TCF Bank had already filed a complaint to challenge the constitutionality of the Durbin Amendment. According to the complaint, the Amendment, would prohibit many debit card issuers from charging fees sufficient to recover all of the issuers’ costs, as opposed to merely costs associated with an individual transaction, and would not allow an issuer to receive a reasonable rate of return. In addition, because the Amendment exempts small banks from coverage, it was challenged as arbitrary.3

  1. The Board Meeting

The Board’s consideration of the proposed rule, on December 16, was telecast live, and viewers who had hoped that the Board would somehow ameliorate the constitutional flaws of the Durbin Amendment were disappointed. Instead of finding a way to conclude that other non-transactional costs and a reasonable rate of return could be included in the standard of “reasonable and proportional” to a transaction’s cost, the Board proposed a 12 cent per transaction cap.4

  1. The Cap

The statute allows the Board to propose standards for assessing whether a fee is reasonable and proportional to a transaction’s cost. Board-proposed standards could have explained factors to be considered by issuers in determining whether proposed fees are “reasonable and proportional.” Further, the proposed rules could have defined those terms. The staff explained that it chose, instead, to recommend a simple rate cap in order to reduce the administrative burden that may come from having to demonstrate various and multiple categories of costs associated with rates assessed. The memorandum from the staff to the Board explains that the administrative burden the staff sought to avoid is in implementation and enforcement5, a burden seemingly not on issuers, but on the Board and its staff.

Some experts had expected the Board would find a way to enable an issuer to recover both more than certain costs of its debit card program and a reasonable rate of return. Instead, the Board proposed a 12 cent per transaction cap on debit card interchange fees6, that being approximately the 80th percentile of the costs of covered issuers’ authentication, clearing, and settlement7. By approving the proposed rule as it did, the Board will only permit 80 percent of issuers to recoup all of their per transaction costs, but not costs such as card production and distribution, research and development, marketing, responding to customer inquiries, and overhead. That also means 20 percent of issuers will not even be able to recoup all of their per transaction costs8. Some issuers reportedly have already decided to terminate their debit card services, even though many Board members expressed concerns at the meeting that their intention was not to discourage initiative and creativity in development of payment systems. The Board did not seem to appreciate the impact its proposal would have on this desired policy goal, although, in response to a question from Vice Chairman Janet Yellen, the staff acknowledged that this proposal would retard the growth of debit card services.

  1. Costs related to Fraud Prevention

No legislative hearings were conducted to provide Members of Congress with information on the practical impact of the Durbin Amendment. However, Congress did hear objections raised that even fraud prevention costs would not be recoverable under an earlier version of the Amendment. Consequently, the final version of the legislation did include authority for the Fed to consider including fraud prevention costs. The Dodd-Frank Act prescribed a date by which rules in this area were to be adopted—April 21, 2011. However, the Board’s staff, at the December 16 meeting, acknowledged that a rule permitting recovery of fraud prevention costs would not be ready by April 21, 2011. Thus, despite Congress’ responsiveness to the need to recover fraud losses and fraud prevention costs, issuers will not be permitted to recover costs of fraud prevention if a 12 cent rate cap goes into effect on July 21, 2011. This is confusing. Because the Board will not be able to adopt regulations in a timely enough manner, the ability of issuers to recover fraud costs will be held up until such time as final regulations are adopted. The staff memo to the Board suggested that the median amount spent on fraud prevention by issuers the staff surveyed was 1.8 cents per transaction.

  1. Impact on Consumers

There has been considerable debate about whether merchants will pass along their savings on interchange fees that will come from this proposal, in the form of reduced prices, or whether they will merely retain the savings as profit. The Board’s staff, however, seemed to accept as a given that prices will be reduced and consumers will benefit in markets where there is strong merchant competition. However, the Board’s staff acknowledged that ultimately covered issuers are likely to raise other fees and discontinue debit card benefits, such as rewards programs. These changes will impact costs to consumers. Smaller banks are exempt from the Durbin Amendment and may continue to charge higher debit card interchange fees than larger issuers. While larger issuers may try to recover costs by imposing fees and reducing rewards programs, smaller banks will not have to do so, creating a competitive advantage over larger banks in attracting retail deposits. Merchants would be prohibited from discriminating against different issuers of debit cards and will not be able to reject debit cards issued by smaller banks that charge higher debit card interchange fees.

  1. The Staff Memorandum

In presenting the proposal to the Board, the staff prepared a 14- page memorandum transmitting and explaining the 163-page Notice of Proposed Rulemaking (“NPR”).

  1. Similarities to Checks

The memorandum recognized that the statute directed the Board to consider the functional similarity between debit card transactions and check transactions that clear at par through the Federal Reserve. Of course, merchants are not charged a fee for check transactions. However, merchants likely bear a higher risk of fraud and return for insufficient funds with check transactions than they do with debit card transactions, particularly PIN debit card transactions.

Some experts had expected the Board would find a way to enable an issuer to recover both more than certain costs of its debit card program and a reasonable rate of return. Instead, the Board proposed a 12 cent per transaction cap on debit card interchange fees6, that being approximately the 80th percentile of the costs of covered issuers’ authentication, clearing, and settlement7. By approving the proposed rule as it did, the Board will only permit 80 percent of issuers to recoup all of their per transaction costs, but not costs such as card production and distribution, research and development, marketing, responding to customer inquiries, and overhead. That also means 20 percent of issuers will not even be able to recoup all of their per transaction costs8. Some issuers reportedly have already decided to terminate their debit card services, even though many Board members expressed concerns at the meeting that their intention was not to discourage initiative and creativity in development of payment systems. The Board did not seem to appreciate the impact its proposal would have on this desired policy goal, although, in response to a question from Vice Chairman Janet Yellen, the staff acknowledged that this proposal would retard the growth of debit card services.

  1. Costs related to Fraud Prevention

No legislative hearings were conducted to provide Members of Congress with information on the practical impact of the Durbin Amendment. However, Congress did hear objections raised that even fraud prevention costs would not be recoverable under an earlier version of the Amendment. Consequently, the final version of the legislation did include authority for the Fed to consider including fraud prevention costs. The Dodd-Frank Act prescribed a date by which rules in this area were to be adopted—April 21, 2011. However, the Board’s staff, at the December 16 meeting, acknowledged that a rule permitting recovery of fraud prevention costs would not be ready by April 21, 2011. Thus, despite Congress’ responsiveness to the need to recover fraud losses and fraud prevention costs, issuers will not be permitted to recover costs of fraud prevention if a 12 cent rate cap goes into effect on July 21, 2011. This is confusing. Because the Board will not be able to adopt regulations in a timely enough manner, the ability of issuers to recover fraud costs will be held up until such time as final regulations are adopted. The staff memo to the Board suggested that the median amount spent on fraud prevention by issuers the staff surveyed was 1.8 cents per transaction.

  1. Impact on Consumers

There has been considerable debate about whether merchants will pass along their savings on interchange fees that will come from this proposal, in the form of reduced prices, or whether they will merely retain the savings as profit. The Board’s staff, however, seemed to accept as a given that prices will be reduced and consumers will benefit in markets where there is strong merchant competition. However, the Board’s staff acknowledged that ultimately covered issuers are likely to raise other fees and discontinue debit card benefits, such as rewards programs. These changes will impact costs to consumers. Smaller banks are exempt from the Durbin Amendment and may continue to charge higher debit card interchange fees than larger issuers. While larger issuers may try to recover costs by imposing fees and reducing rewards programs, smaller banks will not have to do so, creating a competitive advantage over larger banks in attracting retail deposits. Merchants would be prohibited from discriminating against different issuers of debit cards and will not be able to reject debit cards issued by smaller banks that charge higher debit card interchange fees.

  1. The Staff Memorandum

In presenting the proposal to the Board, the staff prepared a 14- page memorandum transmitting and explaining the 163-page Notice of Proposed Rulemaking (“NPR”).

  1. Similarities to Checks

The memorandum recognized that the statute directed the Board to consider the functional similarity between debit card transactions and check transactions that clear at par through the Federal Reserve. Of course, merchants are not charged a fee for check transactions. However, merchants likely bear a higher risk of fraud and return for insufficient funds with check transactions than they do with debit card transactions, particularly PIN debit card transactions.

  1. The Cap and Costs

In the memorandum, the staff explained its decision to impose a cap based on average variable cost for all covered issuers, instead of tailoring standards to an individual issuer’s costs. The staff argued that, in determining whether a fee is “reasonable,” the Board should consider whether the fee is fair and proper not only in relation to the individual issuer’s costs, but to the costs incurred by all covered issuers. While the premise for the Staff’s position is not explained, presumably, Staff believes that to determine whether a fee is “reasonable,” the Board needs to look at practices of all other issuers. Similarly, the Staff without a stated rationale concluded that, to be “proportional,” an interchange fee must not be based on a ratio of costs to interchange fee, but rather on a flat safe harbor number or cap based on industry averages.

The memo recommended two alternatives: (1) a combination of issuer specific standards with a 12 cent cap and a safe harbor of seven cents, i.e., issuers with costs in excess of seven cents per transaction would be permitted to recover their average variable costs of authorization, clearance, and settlement up to 12 cents per transaction; or (2) a 12 cent cap. Staff suggested a cap is necessary as an incentive to force issuers to control costs, apparently dismissing the notion that competition and normal profit motives are sufficient incentives to control costs in the debit card area.

The Board is required by the NPR to re-evaluate the cap and safe harbor numbers every two years based on data to be collected from issuers on their costs.

  1. Possible Fees to Cardholders

The staff suggested, in its memorandum, that nothing prohibits an issuer from charging fees to cardholders. At the Board meeting, Board Chairman Bernanke asked the first question, which was why the free market should not operate to keep interchange fees competitive? The staff explained there exists a “third-party pay” problem, whereby the person choosing to use the bank’s debit card service — the cardholder — does not pay the interchange fee that comprises the costs to use that service. Instead, the merchant pays the costs of the consumer’s decision to pay by debit card.

  1. Network Fees

The memo also urges prohibition of per-transaction rebates or incentive payments to issuers by networks to address the possibility that parties would use these tactics to circumvent or evade the NPR’s purpose.

  1. Fraud Prevention Costs

As mentioned above, the statute authorizes the Board to permit recovery of fraud prevention costs (as opposed to fraud losses) if an issuer complies with fraud prevention standards set by the Board. As also mentioned above, in the staff’s survey of issuers, the median amount spent by issuers on fraud prevention equated to 1.8 cents per transaction. The staff memo noted that many of these costs might not be appropriate for consideration because they related to the overall account relationship and not to specific debit card transactions. Early versions of the bill permitted recovery of per transaction costs, but was revised to permit the recapture of fraud prevention costs in addition to per transaction costs. That suggests that recovery of per transaction fraud prevention costs would have always been permitted even before the bill was revised to permit recovery of fraud prevention costs and, thus, the revision contemplates recovery of more than just per transaction fraud prevention costs. In other words, the legislative history of the Durbin Amendment suggests that issuers should be permitted to recover fraud prevention costs even if the costs are general and not limited to individual transactions. As mentioned above though, the proposal does not provide for recovery of fraud prevention costs. That is because, according to the Staff memorandum, the Staff is not yet able to determine which fraud prevention activities are effective and, what is more, which are cost-effective. Nothing in the statute provides for effectiveness or cost-effectiveness to be a standard the Board is to consider, but the statute does permit the Board to consider such factors as it deems appropriate.

Instead of proposing that all fraud prevention costs be recoverable, the proposal set forth two general approaches and asked questions. The first approach would use the Board’s rate-setting authority to spur innovation that might reduce industry fraud losses by identifying “paradigm-shifting technology” that would likely result in substantial reductions in total industry-wide fraud losses. The cost of such technology would then be determined, and recovery of the cost of such technology would be permitted. However, that might essentially discourage industry pursuit of even better unidentified technologies, and, in any event, the effectiveness of such technology might be difficult to measure. The second approach would be less prescriptive and would credit fraud prevention approaches chosen by issuers, possibly up to a cap. The legal basis of capping credited fraud prevention expense is not addressed in the memorandum. The Staff worries that this approach may not provide issuers with incentives to control costs. The effect of the profit motive to create such incentives is not mentioned.

  1. Network Exclusivity and Routing

Finally, the memorandum addresses network exclusivity and routing, the oft-forgotten step-children in the Durbin Amendment. The statute requires the Board to adopt regulations prohibiting issuers and networks from restricting the number of networks over which a debit card transaction may be routed to a single network or family of affiliated networks or from inhibiting a merchant to route over a particular network. These would apply to small and large issuers and also apply to all prepaid cards as well. Currently, debit card transactions route over one of two types of networks, depending on how the cardholder authorizes the transaction. If the transaction is PIN-based, the transaction is routed over network infrastructure similar to that used for ATM transactions, using the same message for authorization and clearing. If a debit card transaction is signature-based, it is routed over the same network infrastructure used for credit card transactions, requiring two messages for completion: one authorization message and a later clearing message. The proposal suggests two alternatives to implement the prohibition against issuers and networks restricting the number of debit card networks to a single network or family of networks. The first alternative would be to recognize that unaffiliated PIN-based and signaturebased networks and their continuing availability would avoid the prohibition. The second alternative would require that there be two PIN-based networks and two signature-based networks. The Board’s staff recognizes that this second alternative would require major changes to network and processor infrastructure because, while the technology may currently exist for multiple PIN-based networks, systems are not in place at this time to handle multiple signature-based networks on the same debit card.

  1. Notice of Proposed Rulemaking

The new proposed rule would be new Federal Reserve Regulation II. It would be effective July 21, 2011.

  1. Applicability to ATM Transactions?

While the legislative history of the Durbin Amendment limits the scope of this to the use of debit cards at merchants, i.e., point of sale transactions, the Board expressly, in its notice, asks for comment on whether the proposed rule should apply to ATM transactions and networks. The statute expressly requires the Board to set fees for “electronic debit transactions,” and the statutory definition of that term (“a transaction in which a person uses a debit card”) is broad enough to encompass ATM transactions. This might be an example of overbroad drafting that might have surfaced and been remedied had conventional hearings been held on the Durbin Amendment.

  1. Foreign Transactions

The proposal carefully excludes transactions in which a debit card is used outside the United States by defining the term “electronic debit transaction” to be a transaction in which a person uses a debit card for payment in the United States.

  1. “Reasonable and Proportional” to Cost and the 12 Cent Cap

The Board’s notice asserted that, in considering whether an interchange fee is “reasonable,” the Board is not limited to considering the fee’s relationship to the individual issuer’s costs, but may consider costs incurred by other issuers, even if an individual issuer’s costs are above that level. It also consciously rejected the concept that to be “proportional” to costs, an interchange fee must have a certain ratio to costs. (In other words, if the Board adopts the 12 cent cap, the ratio to costs essentially would be disregarded, and proportionality would simply be deemed to exist.)

The statute9, however, expressly provides that the amount of any interchange transaction fee that an issuer may receive or charge be reasonable and proportional to the cost “incurred by the issuer” with respect to the transaction. The use of the definite article “the” suggests that the fee limitation should be determined separately for each issuer based on its costs. The Board acknowledges that, but believes that the approach set forth in the statute literally requires determining the cost of each individual transaction before the fee is charged and thus is impractical and difficult to administer and enforce and would introduce undesirable economic incentives. Thus, one alternative it proposes is determining issuer-specific costs. However, it would impose a cap on those costs based on industry-wide costs, which would seem to derogate from the statutory requirement that the fee be based on the “cost incurred by the issuer” (emphasis added). The Board disfavors that approach because it does not provide an incentive for issuers to control their costs. The Notice expresses concern that “an issuer that is eligible to recoup its costs under an issuer-specific determination with no cap would face no penalty for having high costs.” However, while incenting efficiency is a worthy goal, it does not appear to be related to the statute’s purpose or letter, and it is not clear what legal authority the Board has to impose penalties for having high costs. The Board also expressed concern in the Notice that an issuer-specific determination might also encourage over-reporting of costs by an issuer in order to get a higher interchange fee. The Notice notes that economists have advocated against regulation based on cost of service, but that appears to be precesely what Congress has directed here. Thus, to address the incentive problems, the Board has proposed the 12 cent cap.

High costs of authorizing, clearing, and settling may be caused by many things. A small program targeted at high-net-worth customers might have higher transaction costs. A start-up program that has not achieved economies of scale yet might also for their high costs and suggests that other sources of revenue, such as cardholder fees, may help to cover such costs.

The sample the Board tested had average per-transaction variable costs of 13 cents, but were only four cents when weighted by the number of transactions. The 50th percentile was approximately seven cents. The 12 cent cap significantly reduces interchange fees from the current average of 44 cents per transaction, but allows for recovery of variable costs for 80 percent of covered issuers. Of course, that means 20 percent of issuers will not be able to recover their variable costs using interchange fees. Costs may vary based on authorization method as signature-based transactions may cost more to process than PIN-based transactions, but the Board has not proposed making a distinction between the two, although it invited comments on the idea.

The Board actually proposed two alternatives, first, a seven cent safe harbor with a 12 cent cap if an issuer can justify more than seven cents of costs and, second, simply a 12 cent cap. If the Board adopted the first alternative and an issuer’s network declined to undertake the burden of establishing individualized interchange transaction fees, an issuer could find itself facing, in effect a seven cent cap, since interchange fees are actually set, in the final analysis, by networks.

  1. Similarities to Checks

The statute directs the Board, in prescribing regulations under the Durbin Amendment, to consider the functional similarity between electronic debit transactions and checking transactions that clear at par. One significant dissimilarity is that debit card transactions only proceed if payment is authorized, which requires the issuer determining that the card is valid and that there are sufficient funds to cover payment. Thus, a merchant accepting a debit card knows that payment likely is final. However, in the case of a check transaction, the merchant has the risk that the check will later be returned unpaid. Thus, the merchant, in the case of a debit card transaction, may have to pay a transaction fee, but it is assured of an increased likelihood of finality of payment, an assurance it does not get when it accepts a check and avoids paying a transaction fee. The Board’s notice notes that a merchant accepting checks can purchase value-added check verification and guarantee services from third-party service providers. However, it does not compare the amounts of the cost of such services to merchants with the amounts of electronic debit interchange transaction fees currently imposed on merchants.

The Board does explain that there are more processing and collection costs borne by merchant-acquiring and card-issuing banks and payable to the networks in the debit card area, whereas in the check collection scenario, the payor’s bank does not incur fees to receive non-electronic check presentment.

  1. Allowable Costs

The Board, following the statute, only considered, in its ratesetting, incremental costs of authorization, clearance, and settlement of individual transactions. It recognized that there are individual transactions costs (e.g., cardholder rewards paid by the issuer for each transaction, dealing with cardholder inquiries and complaints about a particular transaction) that are not attributable to authorization, clearance, or settlement, but the Board felt bound by the statute not to consider those other individual transaction costs. Nonetheless, the Board expressly invited comment on whether it should consider transactional costs beyond those of authorization, clearance, and settlement. However, it also expressly invited comment on whether it should only limit allowable costs to those of authorization and not include the costs of clearance and settlement since banks do not charge analogous fees for clearing and settling check transactions.

Surprisingly, while the Board acknowledged that network processing fees (i.e., “switch fees”) are paid by issuers in order to ensure authorization, clearance, and settlement, the Board proposes to exclude such switch fees from allowable costs in order to avoid merchants, in effect, indirectly paying such switch fees. The Board did not explain why that would be undesirable, which is especially unfortunate when it is considered that, in traditional paper check collection, the merchant indirectly (or at least the merchant’s bank directly) pays all processing costs10, and the Board is required by the Durbin Amendment to consider similarities to check collection. The statute requires Board consideration of “incremental” cost. The Board notes that there is no single generally accepted definition of that term and proposes that the standard include the per-transaction value of costs that vary with the number of transactions, i.e., average variable cost, which excludes overhead and other costs of maintaining deposit accounts that would not be avoided if an issuer did not have a debit card program. Conversely, this means that, where variable costs of authorization, clearance, and settlement of debit card transactions are shared with credit card operations (i.e., where the costs are recorded jointly in internal cost accounting systems or are not separated on thirdparty processing invoices), a portion of the costs may be properly allocable to debit cards based on proportionality. The upshot of all this is that issuers, in their cost accounting, would have to separate variable costs from fixed costs if the Board adopts a safe harbor of seven cents per transaction with a cap of 12 cents that may be have higher transaction costs. The Board has concluded that it is not reasonable for the interchange fee to compensate such issuers reached by an individual issuer’s demonstrating its variable costs exceed seven cents. Nonetheless, the Board expressly invited comment on whether it should include fixed costs in the cost measurement.

  1. Fraud Prevention Costs

The statute provides that the Board may allow for an adjustment if it is reasonably necessary to allow for costs incurred by the issuer in preventing fraud in that issuer’s electronic debit card transactions and the issuer complies with fraud prevention standards established by the Board.11 Senator Durbin, on the floor of the Senate, described this as being applicable on an issuerspecific basis because that is the only way it can be determined that an issuer complies with Board standards.

Issuer fraud prevention activities, of course, include transaction monitoring and fraud risk scoring systems that may trigger an alert or call to the cardholder to confirm the legitimacy of a transaction, as well as merchant-blocking and account-blocking. Fraud prevention costs also include customer servicing associated with fraudulent transactions and personnel costs for fraud investigation teams. The total of such fraud prevention costs approximates 1.6 cents per transaction. Data security costs approximated another 0.2 cents per transaction.

As mentioned above, one alternative the Board is considering is only permitting the recovery of all or some of the costs of “paradigm-shifting technology” that would have the potential to reduce fraud losses substantially. Such technologies include end-to-end encryption, tokenization, chip and PIN, and the use of dynamic data, no one of which is broadly used in the United States at this time. Obviously, permitting the recovery of all or some of the costs of such technology would incent the adoption of such technology, but it would also discourage investment in other new technology that might be more effective or less costly.

The other alternative would be a non-prescriptive approach that would give issuers more flexibility. This would permit recovery of some or all current and new fraud prevention costs. Since such costs would be recoverable in interchange fees charged merchants, the Board considers this to constitute a shifting of those costs to merchants which are already bearing cardrelated fraud prevention costs though charge-backs, particularly with signature-based debit card transactions. (The Board even asked whether issuers should only be permitted to recover fraud prevention costs that benefit merchants12.) The Board noted that this non-prescriptive alternative would incent issuers to invest in fraud prevention, but the Notice notes the irony that, in payment systems that do not utilize cards, financial institutions already invest in fraud prevention without reimbursement of those costs from counter-parties What costs constitute fraud prevention costs gets particularly thorny when it is realized that some fraud prevention activity, such as know-your-customer due diligence at account opening, is not specific to card transactions. The Board asked whether such costs should be recoverable.

Another issue here is whether the Board should incent PIN-based debit card transactions and steer the industry away from the more fraud-prone signature-based transactions. Permitting recovery of fraud prevention costs only for PIN-based transactions would have that effect.

  1. Where We Are

The Board has received more than 11,000 comments on the proposal, many of which are quite detailed and extensive, and Board Chairman Ben Bernanke has written to the Chairmen of the relevant House and Senate Committees informing them that that Board will be unable to meet the statutory directive that final interchange fee standards be issued by April 21, 2011, but promising to complete the rulemaking in advance of July 21, 2011. Meanwhile, Representatives Shelley Moore Capito (R-WV) and Debbie Wasserman Schultz (D-FL) have gained 70 co-sponsors to H. R. 1081, the Consumer Payment System Protection Act, which would delay the Board’s interchange proposal for one year after enactment and require an inter-agency study of the effect of the Durbin Amendment with a report to Congress eight months after enactment. On the same date that H. R. 1081 was introduced, March 15, 2011, Senator Jon Tester (D-MT) with 10 co-sponsors introduced S. 575, the Debit Interchange Fee Study Act of 2011, which would extend the April 21, 2011 deadline by which the Board is to issue a rule on debit card interchange to a date 24 months after enactment, during which time the banking agencies would conduct a study and issue a report to Congress.

Based on the level of controversy engendered by the legislation and the Board’s proposal, any additional time the Board might take to consider and address the dramatic impact of this proposal would be time very well spent.