Accounting debit and credit rule

A profit setback for banks may be made up in volume

Anticipation consumed the debit card industry in April: what would the antitrust case against Visa and MasterCard mean for so called off-line cards? After the smoke cleared, one thing was abundantly clear banks would make less money on debit transactions.

The debit card saga began in October 1996 when merchants and their trade associations filed a lawsuit against Visa USA and MasterCard International. At issue were the rules Visa and MasterCard set for merchants that agreed to accept their credit cards. The merchants, spearheaded by WalMart, asserted that the card networks violated federal antitrust laws by illegally "tying" the acceptance of debit cards to credit cards. According to the merchants, this "tying" was accomplished by the "Honor All Cards" rule, which required merchants to accept all Visa and MasterCard branded cards, not just credit cards, if the merchant agreed to accept any cards for payment.

The trial began April 28, 2002. Thirteen months later, Visa and MasterCard settled with the merchants, agreeing to drop the Honor all Cards rule. Additionally, the networks immediately lowered the interchange rate for debit transactions by one-third. (National interchange rates are set by the Visa/ MasterCard system and dictate the cost of processing debit transactions.) The two card networks also agreed to pay the merchants $3 billion.

The agreement originally dictated that the card networks change the rules on Jan. 1, 2004, but the deadline has since been extended 30 days to keep point-of-sale systems stable throughout the busy holiday shopping season. With the court case resolved and the acceptance rules about to change, how have banks been affected and what is the outlook for next year?

The $375 million State Bank of Cross Plains, Wis., has lost $30,000 in debit card revenue since the settlement, according to Charles Saeman, the bank's president.

"For a bank our size, that's not tremendously huge overall, but it is a significant loss for one product line to take" said Saeman, who thinks the next few years will see interchange rates and transaction volume strike a balance where profits may rebound.

"Probably there will be a general review of the entire card industry in terms of pricing," said Saeman. "I suspect debit card promotion will increase. There will be a greater effort to get the overall volume of sales up to offset the difference in interchange."

Bank Mutual, Milwaukee, offers a check card that functions both as an online and off-line debit instrument. Bank President Michael Crowley, Jr., said the bank is in a wait and see mode. "We've lost 25 to 30 percent of our revenue from debit cards," said Crowley. "We'll have to see what happens to the rate next year. Since merchants will no longer have to accept all forms of payment, depending on what happens to the rate, the numbers might go down."

As for the Honor all Cards rule, Crowley thinks merchants will continue to honor off-line debit cards. "Only the largest retailers like WalMart will have the clout to make a decision like that, but that could alienate many customers," said Crowley. "If they do decide not to take these cards, I think they'd have a lot of unhappy customers, and merchants aren't in business to make their customers unhappy."

Winners and losers

The cost of debit transactions may be up in the air, but the tidal wave of electronic payments is undeniable. Many consumers have come to rely on plastic and reverting to older payment methods is highly unlikely. The settlement may pan out to bo a minor chink in the armor of unstoppable progress.

"The cost of handling cash and checks would probably be greater than anything we're talking about with the interchange fees," said Crowley. "As a merchant, nobody is guaranteeing the checks for you, so there will be a collection cost. I don't see people wanting to go back to this system."

If the settlement has produced a clear loser, besides the near-term profitability of debit products, it's debit card reward programs - incentive programs like those that accumulate airline miles with each debit purchase.

The State Bank of Cross Plains offers a reward program with its credit cards but not its debit cards. The bank was considering implementing a program on the debit side, but the settlement made that decision for them. "Now, we're actually looking at our rewards programs across the board and we'll be making a determination as to whether we will continue to offer them," said Saeman, adding that the revenue loss on the debit side makes funding these programs difficult.

David L. Petro agreed that reward programs are on the chopping block. Petro is an executive vice president at ICBA Bancard, the card subsidiary of the Independent Community Bankers of America. The company has more than 3,000 product relationships with community banks. "Points programs for debit cards were turning into an industry norm," said Petro. "That changed overnight after the settlement. Right now everyone is trying to figure out whether they can afford to offer those programs."

If the settlement has produced a clear winner so far, it's merchants who have been paying less for debit transactions. "In the months since the settlement, merchants expect to save $850 million from the reduced interchange rate," said Cindy Ballard, a representative for Pulse, an electronic funds transfer network. "Of course, that's money the banks will not make. And that's only five months worth."

Consumers, so far, have neither gained nor lost. Ballard said electronic transfer volumes didn't bat an eye following the settlement.

"It's not affecting the consumer side yet, if ever," said Ballard. "Fees to the retailers have gone down, so that hasn't decreased volume. The only group that has negatively been affected by this in any real way are the financial institutions."

Still squared off

The debate over the interchange rate remains loud because it is likely to change again as the market ad justs. While some believe lost revenue to the banks is only the first in a series of increased costs, others think the rates will assume market value, card volume will increase, payments will become more efficient and everyone - banks, merchants and consumers alike - will be better off in the long run.

The Independent Community Bankers of America and its ICBA Bancard subsidiary are critical of the lawsuit and settlement.

"The settlements, after millions of dollars of legal fees, will only serve to devalue and potentially Balkanize the United States' efficient payment processing systems," said ICBA President Kenneth Guenther upon the settlement announcement.

ICBA Bancard's President, Linda Echard, remains skeptical of nearterm prospects for rebounding profits and thinks the settlement creates a slippery slope.

"Certainly when banks were planning their budgets for 2003, they did not anticipate a case like this wiping out a third of their income for one of their products - an income that really wasn't that enormous in the first place," said Echard. "And remember, Visa and MasterCard do not issue cards. They are merely bank associations. all association members are paying the lawyer tab and settlement tab for this suit. all members will suffer from the diversion of their resources from marketing and developing new products."

Echard continues to be an outspoken critic of the settlement, and is quick to say it won't help consumers or merchants and has negatively affected banks. An editorial she has written currently appears at the educational web site www.payingwithplastic.org. Echard writes:

"No one quibbles with the position that banks were on the losing side of the settlement. They, after all, are the ultimate funding source for the payouts of the card associations and they are the ones that will have to absorb the sudden interchange reduction of 25 to 30 percent this year and future revenue is, at this moment, completely uncertain. At best case, debit card issuers netted only about 30-cents a transaction, pre-tax, before the settlement. It is my guess that Wal-Mart makes more than that just on the sale of one loaf of bread."

Visa sees things differently. The card network that commands 80 percent of the card market has reported that in spite of the settlement, debit cards - which the company brands as the Visa Check Card - remain a popular product and the number of debit card customers has grown in 2003.

"Visa remains very bullish about the future of the check card as it continues to be an enormously successful product for Visa, merchants and member financial institutions," said Daniel Tarman, a Visa vice president.