How Smaller Financial Institutions Can Make the New Fed Debit Card Regulation a Win for Customers

It’s time for innovative banks and credit unions to redesign checking — fast.

In early October, the Federal Reserve finalized a rule, known as Regulation II (Debit Card Interchange Fees and Routing), that requires every debit card transaction to have access to two unaffiliated payment card networks. This rule extends the existing regulation from PIN debit transactions to card-not-preset (CNP) transactions and enables merchants and acquirers to choose from competing networks with the intent to lower their debit card processing costs.

With this new rule, a large proportion of CNP transactions, including e-commerce purchases and recurring payments, could (and likely will) end up on networks other than Visa or Mastercard, where interchange fees are lower.

Why change the regulation? The Fed’s rationale is that technology has advanced to properly support CNP with multiple networks.

While there is no modification to requirements related to interchange fees, this change will negatively impact banks’ and credit unions’ payments revenue and, likely, increase their fraud-related costs.

The pandemic helped accelerate consumers’ digital activity, and, as a result, CNP transaction volume has soared in the past two years. Historically, 50% of CNP transactions were on the signature debit rails. With the rule change, a percentage of financial institutions’ revenue from related debit/CNP transactions will be cut in half.

There’s Plenty of Prep Work to Be Done

Although the regulatory change doesn’t require banks and credit unions to make any technology changes, they shouldn’t idly sit by waiting for the new rule to take effect. In “New Durbin Regulation, Now What,” a recent Cornerstone Advisors webcast, Brandi Gregory, managing director, and Tony DeSanctis, senior director, in Cornerstone’s Payments Practice, outlined three things financial institutions should do:

• Analyze current transaction volume. Banks and credit unions need to analyze their current transaction volume distribution and forecast the financial impact of a portion of CNP debit card transactions on the networks they have agreements with today. The Federal Reserve reported that 23% of debit card transactions were CNP in 2019. According to Pulse, a debit card network, one in three debit purchases were CNP and represented, on average, 7.5 purchases per month for a debit card user in 2020.
• Analyze transaction volume by the network. Financial institutions that currently use multiple unaffiliated networks should cut back to no more than two by July 1, 2023, to help mitigate the potential revenue shortfalls. The timing of this change comes as some institutions have already made budget decisions based on existing debit card revenue trends for 2023. These financial revisions may have a downstream effect on 2023 projects as revenue expectations are adjusted.
• Assess the fraud implications of the amended regulation. CNP transactions carry a greater inherent risk of fraud, and the volume of single-message transactions will likely increase. Dual message transactions by design have a greater probability to get in front of fraud activity. Debit card issuers should check the CNP fraud resolution rights afforded by their networks to verify how they’re covered.

Go On the Offense With a Redefined Checking Account

The Federal Reserve’s goal for the revised debit rule is to promote competition, thus reducing costs for merchants and, ultimately, prices for consumers.

It’s reminiscent of how the 2010 Durbin Amendment was supposed to save money for consumers. Not surprisingly, merchants did not pass the savings on to customers. In 2015, the Fed found that because of the 2010 regulatory changes, only 1.2% of merchants reduced prices. Consumers lost in 2010 and they will lose again in 2023.

This regulatory proposal coincides with a broader industry trend. A structural shift in the economics of a checking account has occurred over the past two years. Revenue from overdraft to interchange has been squeezed, and smaller debit card issuers are feeling it far more than large retail banks.

Small and mid-size institutions need to innovate and redesign the checking account to increase the value the product delivers. Doing so will involve some combination of three strategies:

• Value-added services. Cornerstone Advisors' research indicates that more than half of consumers between the ages of 21 and 55 are interested in getting value-added services from a financial institution. Banks and credit unions should study their customers and members and identify services that complement them and the institution’s brand. However, just offering debit card rewards in the current environment will prove to be extremely cost punitive, so FIs should consider migrating to relationship-based rewards versus spend-based rewards.
• Relationship value. Seasoned bankers know a checking account can be the foundation of a profitable relationship. Today, it is common for consumers to hold multiple checking accounts, making loyalty challenging and even demoting banks to paycheck motels. Effective designs will provide customer value for profitable behavior such as bonus interest on deposit balances or savings on a mortgage loan origination.
• Financial security. Banks and credit unions are positioned to help customers be financially resilient. Initiatives that gracefully integrate data with targeted banking solutions provide institutions with an opportunity to own more of the customer’s share of wallet. No “boil the ocean” or financial management programs here; consider a targeted program such as bonus interest or a cash reward when a savings goal is achieved and tied to a loan down payment.

Banks and credit unions seeking to redefine the checking account value exchange will have a longer list than those suggested here. To win this war, institutions need to act with speed and agility, and those that deliver on this premise will also provide victories for customers.