By Patricia A. Murphy

There’s no denying the importance of debit and credit card interchange to community banks’ balance sheets. In fact, an ICBA survey of community banks earlier this year found little leeway available in community bank debit margins if the effects of government interchange price controls targeting the largest banks trickle down to community banks. Any significant reduction of their debit interchange revenues will almost undoubtedly force community banks to impose higher costs or reduce card benefits and services for their debit card users and checking accountholders, the 2011 ICBA Community Banks Payments Survey found.

If interchange fell significantly for community banks, free checking accounts for one would likely be a thing of the past, according to ICBA’s survey. Nearly two-thirds of community banks reported they would likely have to eliminate those accounts if interchange price restrictions affect their institutions. The same proportion indicated they would likely have to charge for free services, such as online or mobile banking or loyalty program benefits. Nearly 20 percent of community banks report that they might have to eliminate jobs or halt plans for new branch expansions (see more on the survey results here).

Despite unified opposition by ICBA and the banking and credit union industries and by the payment networks, Section 1075 of the Dodd-Frank Wall Street Reform and Consumer Protection Act instructed the Federal Reserve to establish rules limiting debit interchange to what it deemed “reasonable and proportional” to issuer costs. The Federal Reserve determined that it should consider only the costs incurred by the largest card issuers with $50 billion in assets or more. For debit card issuers with assets $10 billion or greater, the Fed ultimately capped debit card interchange at 21 cents plus 5 percent of the purchase total; banks that undertake certain security measures can charge an additional penny per transaction. The Dodd-Frank Act and the Fed’s rule also mandate that all debit card issuers (not just the over $10 billion in assets crowd) ensure their customers’ debit card payments can be processed on at least two unaffiliated payment networks, such as Visa and Pulse, the regional EFT network, beginning next April.

Inevitable outcome?

Even though community banks are exempt from the price cap, many are bracing for powerful market forces in the card payment sector eventually to reduce their precious interchange revenues anyway. “We’re looking at a 20 percent reduction in [debit] interchange between now and next year this time,” says John Buhrmaster, president of First National Bank of Scotia, a $375 million-asset community bank in Scotia, N.Y.

However, any pressure on community banks to lower interchange isn’t likely to come all at once, but as merchants’ acquiring contracts come up for renewal there will be added pressure to renegotiate interchange and other fees. Some debit interchange losses are likely to accrue as a result of changing consumer preferences and marketplace responses to government interchange price controls, some payments experts say. Confronted with higher fees for debit card use, and card issuers mothballing debit card rewards programs, many consumers could shift more of their debit card transactions to credit cards. Or, as a few payments industry observers contend, merchants could nudge consumers toward less costly forms of payment than credit or debit cards, like cash or checks.

“We were quite successful in moving our customers to signature debit from PIN debit,” with an incentive program, points out Steen of Bridge Community Bank. “We know retailers can likewise change their behavior, and they tend to be a lot more sophisticated about that stuff than we are.”

“To be competitive community banks have to lower [interchange] rates over time,” chimes in Paul Martaus, president of Martaus and Associates, a company in Mountain Home, Ark., that advises companies that sell acquiring and related card services to merchants.

Cautious optimism

Not everyone necessarily sees a doom-and-gloom future of community bank debit cards, however. Frank Aloi, president of ATH Power Consulting, a marketing research firm in Boston, believes community banks can continue to earn meaningful profits from debit interchange. Community banks should “rethink” relationships and place greater emphasis on cross-selling and fine-tuning rewards programs to recoup some of the revenues lost to lower interchange, he says. Banks should focus more intently on wooing their most profitable accountholders and card users and not losing sleep over the loss of unprofitable accountholders.

“Figure out who your most profitable customers are and then incent them with account-based benefits,” Aloi advises. Meanwhile, ramp up your bank’s communication with customers, using whatever channels they prefer (website, email, telephone, blogs and social media) to explain what the interchange regulations will mean for them, he adds.

Jackie Hersch, a debit rewards product manager for Fiserv Inc. in Brookfield, Wis., says the company still encounters plenty of community bank interest in debit rewards programs, especially merchant-funded programs. Hersch maintains that merchant-funded rewards programs can still generate profits even if interchange pricing reductions affect community banks. In 2010, Fiserv’s rewards program on average earned $42 per card per year in additional interchange, plus the money collected from merchants, she says.

Dan Fisher, a payments systems consultant with Copper River Group Inc. in Fargo, N.D., says the interchange price-control exemption for community banks offers more opportunities to outperform big bank payments services, particularly in pricing their debit card programs. Community banks should, he contends, “market that they continue to offer points for using debit cards, and that they haven’t added new fees or placed limits on transaction size.”

Linda Echard, president and CEO of ICBA Bancard, ICBA’s payment card services program for community banks, agrees. “Right now community banks have a short window of opportunity,” she says. “It’s an opportunity to capture market share.” And not just with debit card programs, she adds.

“Community banks need to control debit and credit card accounts to position themselves at top of wallet,” whether consumers are using traditional wallets or new mobile and online alternatives, Echard says. “You’re going to see a lot of small financial institutions come to the realization that not having an in-house credit card offering is a real gap in the customer value proposition,” agrees Lee Manfred, a partner at First Annapolis Consulting, a payments consulting firm in Linthicum, Md.

First National Bank of Scotia is already rethinking its credit card strategy in anticipation of lower debit interchange, Buhrmaster says. When the community bank’s debit rewards contract runs out for its customers next year, those accountholders will likely be offered an option to transfer points to a credit card product, he says. In a move that could help make up for lost debit interchange, however, the community bank also is investigating the possibility of starting major new noninterest revenue operations such as an insurance program.