The Fed Drops a Bomb on the Debit Card Market

Visa (NYSE: V  ) and MasterCard (NYSE: MA  ) plunged more than 10% last week, after the Federal Reserve proposed limiting debit-card interchange fees to between $0.07 and $0.12 per transaction -- more than 80% below what's currently charged.

There are a few misconceptions about how these new rules would work, and especially what they'll accomplish.

Judging by the drop, you'd think the rules directly affect Visa and MasterCard. In truth, they don't -- although both companies could be indirectly hurt in a big way.

Interchange fees -- the small amounts charged to merchants each time you swipe a card -- are calculated and collected by Visa and MasterCard. But the money is remitted back to the bank that issued the card; Bank of America (NYSE: BAC  ) and JPMorgan Chase (NYSE: JPM  ) are the largest. These interchange fees are how banks make money on debit cards. (And you thought they were giving you something for free!) Visa and MasterCard make money on additional, smaller fees that are separate from interchange and not affected by the Fed's proposals. The reason bank stocks didn't plunge along with Visa and MasterCard is because they're large and diversified. While lucrative, interchange isn't a make-or-break profit center for large banks.

So if the banks will suffer directly from the new rules, why did Visa and MasterCard fall so hard? Visa actually explains why in its annual report (emphasis mine):

If we cannot successfully defend our ability to set default interchange rates to maximize system volume, our payments system may become unattractive to issuers and/or acquirers. This could reduce the number of financial institutions willing to participate in our open-loop multi-party payments system, lower overall transaction volumes and/or make closed-loop payments systems or other forms of payment more attractive. Issuers could also begin to charge higher fees to consumers, thereby making our card programs less desirable and reducing our transaction volumes and profitability. Acquirers could elect to charge higher merchant discount rates to merchants, regardless of the level of Visa interchange, leading merchants not to accept cards for payment or to steer Visa cardholders to alternate payment systems. In addition, issuers or acquirers could attempt to decrease the expense of their card programs by seeking incentives from us or a reduction in the fees that we charge.

Visa and MasterCard suffer when interchange drops because it makes debit less lucrative for banks; thus, those banks stop pushing debit cards onto their customers. And since debit has been the main growth driver for Visa and MasterCard, this is a big deal. They definitely lose from these rules.

But who wins? That's hard to say.

The Fed's rules are meant to send relief to retailers who say they're often suffocated by interchange fees. Fees had totaled 1%-3% of each purchase, so any profit margin less than that could be wiped out. Some merchants selling low-margin items like newspapers simply stopped selling, because interchange fees not only wiped out profit margins, but ended up turning sales into a loss. The Jacksonville Business Journal tells the story of a 7-Eleven franchise owner: "His profit margin on that newspaper is only 6 cents, but his debit card interchange fee is 12 to 14 cents, meaning he loses money on that transaction."

But it's no sure thing that the proposed rules will in fact help merchants. The merchants significantly hurt by interchange fees are selling commodity-type products (like newspapers) where competition is fierce. In those commodity businesses, any decrease in cost should be passed on to customers via lower prices, or else competition would swoop in with cheaper goods. In that case, you'd think customers would win.

On the other hand, there's no evidence that merchants with pricing power actually pass the savings of lower interchange fees onto customers. Australia, for example, passed similar regulations on interchange fees in 2003, and the Government Accountability Office found that "total merchant discount fees paid by merchants have declined, but no conclusive evidence exists that lower interchange fees led merchants to reduce retail prices for goods." In that case, you'd think merchants win.

But the third factor that neutralizes potential gains to either consumers or merchants is banks. If banks can not longer rake in money from debit interchange, guess what? They're not going to sit idly by and take it. They'll find new revenue sources, such as monthly fees on checking accounts that used to be free, annual fees on credit cards, or higher interest rates on loans. In Australia's case, the same GAO report notes that "costs for card users, such as annual and other fees, have increased."

In the end, I guess I'm skeptical that the new rules will achieve anything except a shuffling of costs. When I read headlines that say the Fed's proposal will bring relief to consumers and small businesses, I can't help but think that's simply not going to be true. Interchange fees might fall, but banking fees will rise.

Fool contributor Morgan Housel owns shares of Bank of America preferred. The Fool owns shares of Bank of America and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On December 20, 2010, at 1:22 PM, PeyDaFool wrote:

    Morgan,

    Although I didn't notice a specific recommendation on stocks mentioned in the article, is it safe to assume from your conclusion that the drop in stock price is unjustified and V and MA may be a good contrarian picks at the moment?

    I picked up shares of V on Friday near the close price and I'm very confident they will produce stellar returns in the future.

    I bought BP when it hit $30.00 a share, it's done phenomenal. I bought V at $67.00 and I expect a similar result with V's shares as I believe it was an overreaction in the market.

  • Report this Comment On December 20, 2010, at 1:23 PM, FutureMonkey wrote:

    Very interesting. Thanks for the explanation. I was wondering why the networks were getting hammered by loss of profit to the banks.

    I think the main shaking of market price is due to uncertainty of impact. I suspect the Fed Reserve will likely modify the proposal after commentary from industry. The 12cent cap seemed to take most observers by surprise and was widely seen as draconian. I don't believe that it is in the feds best interest to cripple the cc/debit networks that are the foundation of our consumer based economy. Can you imagine what would happen if V or MA flexed their muscles and stopped processing tranactions on their networks for a day. The impact to Walmart alone would choke the economy. Not to mention the loss of sales tax revenue to our community coffers. The howl from consumers, merchants, and local governments would be heard around the world. Nope, I just don't see it as in anybody's interest to strangle the Gold goose, just to give a lousy 1% egg to merchants.

    Besides the merchants complaining about drowning in interchange fees are being remarkably short sighted. Every consumer behavior analysis I am aware of shows consumers spend more when using plastic rather than cash. They really want to give up the bonus business of impulse buys to recoup a few cents per transaction. As a service provider that gets paid at the time of service, how can I bill $300 if my client only has $200 in their pocket. I love it when customers use credit or debit cards!

    Further, I believe it is in the merchants promote use of debit and credit cards on EVERY tranaction. In addition to bonus business, electronic transfers are much more secure against pilfering or imbezzlement than cash transactions. There is not a business in the country that has not lost cash to a tempted employee at one time or another. Not to mention peace of mind walking cash deposits to the bank. Shiver.

    As an investment I like V and MA. Networks derive income on the friction of virtually every area of our economy and are growing their global footprint, particularly in areas with a burgeoning middle class, such as India. I suspect this is a blip not a bomb. The toll takers on the money-flow superhighway will find a way to get paid.

    FM

  • Report this Comment On December 20, 2010, at 1:28 PM, TMFDiogenes wrote:

    Interesting stuff.

    Mike has an interesting reply to some of the same issues raised here:

    http://rortybomb.wordpress.com/2010/12/17/katrina-trinko-at-...

    Also, another possible response: just because banks could find other ways of ripping people off, doesn't necessarily mean improving oligopolistic market functioning and leaving more money in the real economy in a particular segment of the market shouldn't be attempted.

  • Report this Comment On December 22, 2010, at 1:00 AM, Ozcutty wrote:

    Yeah picked up some Visa stock also. Visa and MA have a great global duopoly and will be raking in the cash for years to come as the world undergoes an electronic payment revolution. Both businesses are growing at such a fast clip that this won't impact them much. I consider a pwd p/e of 12 and a 5yr peg of 0.74 a bargain for Visa.

    Worse case and the US gets even more draconian, Visa could always spin off their US operations a la Philip Morris. Don't forget they keep their Europe business at arms length already because of this sort of thing.

  • Report this Comment On December 22, 2010, at 2:23 AM, ChrisFs wrote:

    The merchant isn't going to stop selling small items. They are simply going to do what you already see everywhere. Establish a minimum purchase for using a debit card. $5 or more for using a debit card, The person buying a paper will by a 6 pack or a big bag of chips or something and the merchant will come off with a profit.

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