Last week we discussed the provisions of the Dodd-Frank Act in “Does FinReg Address the Material Issues Surrounding our Nation’s Financial Crisis? ^[1]“  This week, we’ll take a deeper dive into the law’s impact on interchange income and ultimately free checking. 

When President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law, many financial service providers’ worst fears were realized.  They know that it will be increasingly more difficult for them to offer a free checking product and other services to their customers. 

^[2]The straw that broke the camel’s back is the new law’s language that directs the Federal Reserve Board to ensure that debit-swipe fees are “reasonable and proportional” to the cost of processing transactions. The provision would take effect a year after the enactment of the Dodd-Frank Act.

An analysis of the free checking account business model details that fee generation is necessary to offset the costs incurred to bring this below-average balance checking product to market.  Given that the Federal Reserve has already limited the amount of overdraft revenue a provider can generate with its new Regulation E prohibition (i.e., financial institutions cannot charge consumers fees for paying overdrafts on ATM and one-time debit card transactions, unless a consumer consents to the overdraft coverage for those types of transactions), the new law will further stem the fee revenue streams needed to support free checking’s viability in the marketplace. 

Account modeling shows that even before the impact of the new Regulation E rules, a free checking account was a “loss leader” for providers from a fully-allocated cost perspective.  When considering just a provider’s direct costs, a free checking account offered a “modest” return.  With the new law’s debit card “price controls” in place alongside the Regulation E requirements limiting NSF/OD revenue, a free checking product offering is untenable for financial institutions to offer from both fully-allocated and direct expense perspectives. 

Such cost realities have not been lost on some financial institutions that already have been sharpening their pencils.   A mid-June Wall Street Journal article (“End Is Seen to Free Checking ^[3],” June 16, 2010) detailed that Bank of America, TCF Financial, Fifth Third and Stellar One have made or are considering changes to their free checking products.

Although the new law’s language on debit card swipe fees supposedly only affects those debit card issuers with assets more than $10 billion, one would be naïve to believe that smaller-asset institutions will not be eventually impacted.  A May 2009 Federal Reserve report (“Interchange Fees and Payment Card Networks: Economics, Industry Developments, and Policy Issues ^[4]”) even admitted that a narrow intervention targeting interchange fees could have effects on competition and pricing throughout the retail payments market.

Accordingly, the new law suggests that the card associations will administer a two-tiered interchange fee structure among their financial institution members. 

More significant, the new law allows merchants/retailers to direct the routing of electronic debit card transactions for processing over any payment card network that may process such transactions.  In essence, the “merchant strategy” (which intends to push consumers to enter a PIN at the point of sale) has been codified, which reverses the value proposition (signature-debit over PIN-debit) for smaller card issuers.

The new law on debit card swipe fees also will impact those institutions offering debit card rewards programs and the consumers who participate in such rewards programs.  The reality is that debit card fee revenue not only subsidizes free checking product offerings but associated rewards programs as well. National consumer research details that just under one-fifth (17 percent) of all households either participate or qualify for a rewards program that offers cash back or rewards points for debit card purchases. (This includes both stand-alone programs and combined credit card and debit card programs.)  The new law on debit card swipe fees will prompt many debit card rewards program sponsors to either revamp their programs or drop them altogether.

Within the context of rewards programs, the new law’s language to curb debit card swipe fees is rather untimely.  On June 28, 2010, the Supreme Court ruled on the Bilski v. Kappos (formerly known as Bilski v. Doll) case.  Specifically, this recent high court ruling rejected Bilski’s patent eligibility claim of a business method or process that was not tied to a new machine and did not affect any “transformation” of matter in the physical world.   As you readers of the Raddon Report may remember, the Bilski v. Doll case was the basis for a May 2009 United States District Court (Middle District of Florida, Fort Myers Division) ruling that invalidated Every Penny Counts’ “rounding” patent and rejected Bank of America’s patent application for its “Keep the Change” program (See “Every Penny Counts and Bank of America: Suitable for a Reprise of The Flying Fickle Finger of Fate Award ^[5]” – June 10, 2009).  The bottom line is that the door appears to be open for financial institutions to offer similar or “look-a-like” programs of B of A’s Keep the Change initiative without fear that they would be subject to a lawsuit that claims a patent infringement. (Check with your legal counsel, I am not an attorney.)  However, with the new law’s language on debit card swipe fees, what is the incentive for institutions to do so?

To our executive and legislative branches of government, no impact on smaller institutions, Poppycock!

All financial institutions are now placed in a position wherein they must revamp their product and service menus to recoup lost non-interest income and improve their operationally efficiencies.  Specifically, such a position requires that they explore other checking account alternatives beyond a free checking account, which suggest that institutions will only be offering free services based upon the value of the relationship that a customer brings.

Finally, this whacked-out, oft-censored senior research analyst will be seeking out the aid of a certain Canadian export to contemplate (i.e., connect the dots) how debit card interchange fees contributed to our nation’s financial collapse.