The financial reform bill has expanded significantly beyond its original scope.  As with most major pieces of legislation, “mission creep” has occurred and almost anything having to do with money is being included.  

One area which impacts business owners directly is the regulation of interchange fees on debit card payment transactions.  Senator Richard Durbin has attempted to regulate interchange fees for many years with little success. 

By including this issue in the financial reform bill negotiation, it is now certain that the fees will be regulated.  The impact on your company’s pretax profit margin is worth celebrating.

What exactly are interchange fees?

Last year, nearly $3.4 trillion in purchases were made on credit or debit cards.  They are so popular as a form of payment among consumers (who use them) and among businesses (who accept them) that electronic transactions have surpassed cash transactions in the United States.

Almost any store, from a Fortune 100 retail chain to a three-employee bodega accepts them.

The reason for their ubiquity is the existence of the “interchanges”.  Organizations like MasterCard and Visa provide a global electronic infrastructure that allows – in a matter of seconds – for a retailer to confirm if the consumer’s card has sufficient credit or funds to afford the transaction, charge the amount to the consumers card and begin the process of transferring the money to the merchant’s account.  

Credit cards are issued by banks or other financial institutions, who in turn participate in one or several of the interchanges.  This allows their card to be accepted at any business that accepts payments from that interchange.  Without this type of setup, each bank would have to work out individual payment agreements with every business that wanted to accept payment from their accountholders.  It would be a nightmare.

In exchange for providing this service, the interchanges charge businesses that accept payments from participating cards (knows as merchants) an “interchange fee”.  The Interchange fee paid by merchants can vary but is typically between 1-3 percent of each transaction.  This is in addition to all of the other fees associated with a credit or debit card transaction.  The interchange fee is shared between the interchange and the bank issuing the card.

Financial institutions vs. merchants: the merchants won

Interchange fees are not regulated. Since there are only a handful of interchanges, they have tremendous pricing power.  The financial reform bill will change that.  It includes provisions that will regulate interchange fees on debit card transactions.  Credit card transactions will remain unregulated while smaller issuers (financial institutions with less than $10 billion in assets), pre-funded debit cards (that typically target the unbanked) and cards issued to government agencies would be exempt.

The Federal Reserve will set the fees.  It will include specific provisions to ensure the fees are “reasonable” and “proportional” to the value of the transaction.  Industry analysts estimate that this could reduce average interchange fees by 50 percent.

The House of Representatives and the Senate have each passed their respective versions of the financial reform bill.  A final version which reconciled differences in each version was agreed upon in conference committee and is now being prepared for a final vote in both chambers of Congress.  Upon passage it will be sent to the President for his signature, at which point it will be known as the Dodd/Frank Act. 

What was expected to be a simple final approval has now been complicated with the death of Senator Robert Byrd on June 28^th.  Without his vote, supporters of the reform bill only have 56 votes in the Senate. This is enough for passage, but not enough to prevent a filibuster should it occur.

Assuming it passes as expected, and after much lobbying by both the financial and retail industries, it looks like the retailers have won.  The regulation of interchange fees will be part of the final law.

So how much are we really talking about?

According to a recent study by the Nilson Report, a leading payments industry newsletter, total interchange fees paid in 2009 exceeded $64 billion.   Fees associated with debit card transactions represented $20 billion or nearly one-third of the total.  

Use of debit cards has experienced explosive growth over the past few years.  There are now over 500 million debit cards in the U.S. generating 36 billion transactions valued at $1.63 trillion annually.

The effect on your bottom line

This legislation will have a significant impact on your profit margin.  Here is a typical example:

Assumptions

• Annual sales: $20 million
• Pre-tax profit margin: 5 percent
• Pre-tax profits: $20 million x 5 percent  = $1 million
• Percentage of sales paid with debit cards: 30 percent
• Sales paid with debit cards: $20 million x 30 percent = $6 million
• Current interchange fee: 2 percent
• New reduced interchange fee: 1 percent

In this example, the company is paying $120,000 ($6 million x 2 percent) in debit card-related interchange fees. That is equivalent to 12 percent of the pre-tax profit margin ($120,000 / $1 million).  The anticipated reduction in interchange fees would lower this to $60,000 ($6 million x 1 percent), boosting pre-tax profits by 6 percent ($60,000 / $1 million).  In this economy, that’s not bad considering you don’t have to do anything to achieve it.

Prepare for unintended consequences

The impact on financial institutions that will lose tens of billions of dollars in revenues is significant. They will need to find other ways to compensate for these fees.  Since the CARD Act regulates many consumer credit card fees and the mortgage industry is still trying to recover from the housing crisis, banks are left with limited options.  

Expect checking accounts, savings accounts and business credit cards to have new fees levied.  Many free services and rewards will also be eliminated.  Additionally, if you pay your employees or independent contractors with debit cards, the associated costs may go up.