Midtier Banks and Credit Unions Can Compete and Win in Today s Credit Card Marketplace Dennis C. Moroney, Research Director Retail Banking & Cards, TowerGroup October 2011 Executive Summary The combination of the recession and regulatory changes has put severe pressure on revenues and profits of all retail banks and credit unions in the United States. Two regulatory changes will significantly reduce future profits for financial institutions that issue debit cards. The Durbin amendment of the Wall Street Reform and Consumer Protection Act of 2009 (the Dodd-Frank Act) will reduce debit card interchange revenue. Changes to Regulation E (Reg E) will reduce overdraft income. The Durbin amendment will lower the interchange fees that banks can charge merchants for debit card transactions, but Congress expects that some portion of these reductions will be passed on to consumers. The banks are skeptical that consumers will benefit from the amendment. The expectation is that consumers will ultimately pay higher bank fees and receive fewer debit card reward benefits. Merchants' profits will increase because the Durbin amendment reduces the fees that merchants pay to the banks to process debit transactions and the merchants will most likely retain this savings. To support this opinion, the banks cite a 2009 report by the Government Accountability Office (GAO) that examined the circumstances after the Reserve Bank of Australia regulated interchange fees in that market. The GAO concluded that Australian retailers did not reduce prices to reflect their reduced interchange fees. The US Federal Reserve reported that the Dodd-Frank Act would reduce gross annual revenue for US debit card issuers $16 20 billion. The Federal Reserve Board amended the Electronic Fund Transfer Act (Regulation E) in 2010. The changes prohibit banks from charging overdraft transaction fees for ATM withdrawals or one-time debit card transactions unless the consumer has specifically opted in for this overdraft coverage. The change will reduce industry gross revenues for banks and credit unions by more than $15 billion annually. All credit unions and retail banks need solutions to compensate for the expected reduction in revenue and profits from their debit card programs caused by the passage of the Durbin amendment and Regulation E. Because smaller institutions, midtier community banks and credit unions with assets less than $10 billion, rely on interchange, overdraft revenue, and miscellaneous fees to fund their business needs, they are the most vulnerable to the reduction in debit revenues likely to be caused by the regulatory changes. TowerGroup Research is available on the Internet at www.towergroup.com 2011 Tower Group, Inc.
The Business Challenge for Debit Card Retail banking institutions with assets less than $10 billion have historically concentrated their marketing on debit cards. Debit card consumers are relatively inexpensive to acquire, provide a steady source of deposits, and pose minimal credit risk for the institution. The Durbin amendment changes the rules governing the business model for the debit card. Interchange is a major revenue component for both debit cards and credit cards. Debit card interchange accounts for approximately 7.5% of total gross revenue of community banks and 5% of total gross revenue of credit unions in the United States. The Durbin amendment will reduce gross revenues from debit card interchange by over 50%. Industry-wide, interchange accounts for approximately 18% of credit cards' total gross revenue. Credit cards are more profitable than debit cards, whether signature debit or personal identification number (PIN) debit, and the Durbin amendment and Reg E changes will increase the profit gap between debit cards and credit cards. TowerGroup research revealed that in 2009 credit unions earned a mean $175.19 in gross revenue per credit card account compared with $69.41 gross revenue per debit card account. Approximately 80% of credit unions' debit card revenue derived from interchange. Assuming a 50% reduction in debit interchange due to the Durbin amendment, the mean debit card gross annual revenue would be reduced by approximately $28.00, dropping from $69.41 to $41.41. As may be surmised from Exhibit 1, retail banks and credit unions face a difficult business challenge: Consumers insist on rich reward programs. Because the debit card has a thin profit margin that is smaller than the margin for a credit card, banks and credit unions will increasingly rely on various fees to fund debit card programs, yet consumers indicate that fees are a major reason for their switching banks. Exhibit 1 Attrition of US Retail Bank Debit Card Customers by Reason Pricing and product value can be used to retain the best customers No rewards offered 18% 28% Overdraft fees 26% 28% ATM surcharges Poor rewards program Source: MasterCard, TowerGroup Exhibit #: 1 2
The Federal Government Steps In The Wall Street Reform and Consumer Protection Act (the act) and the Durbin amendment will significantly reduce debit card interchange, which produces approximately $16 20 billion annual gross revenue for debit card issuing banks and credit unions. In 2010, as part of its study to collect data for compliance with the Durbin amendment, the Federal Reserve requested comment on the proposed rule that would establish debit card interchange fee standards and prohibit network exclusivity arrangements and routing restrictions. The Federal Reserve study reported the average interchange fee charged to merchants for all debit transactions (signature and PIN) in 2009 was 44 cents. The study reported the median per-transaction total processing cost for all types of debit and prepaid card transactions was 11.9 cents. The median per-transaction variable processing cost was 7.1 cents for all types of debit and prepaid card transactions. The median per-transaction network processing fees were 4 cents for all types of debit and prepaid card transactions. The initial Federal Reserve proposal recommended the allowable maximum interchange transaction fee to between 7 and 12 cents. Limiting the maximum interchange amount to 12 cents reduced interchange income more than 70% from the 2009 average interchange amount. The banking industry submitted their response to the Federal Reserve pricing proposal and convinced the Federal Reserve to reexamine their proposal. A reexamination of the facts resulted in the Federal Reserve issuing their final decision in June 2011. The final Federal Reserve ruling, which includes three parts, increased the ceiling on swipe fees from a 12-cent cap to 21 cents plus 0.05% of the transaction value and 1 cent for compliance with certain fraud protection procedures. The Fed also changed the effective date from July 2011 to October 1, 2011. The Federal Reserve Chairman reported that the 9-cent increase from 12 to 21 cents stemmed from consideration of the network connectivity, labor, hardware and software costs that went into fraud protection. It did not consider other, broader costs like human resources, legal fees and executive compensation. According to the Fed, 21 cents is the 80 th percentile of fraud costs, and that the cap satisfied the reasonable and proportional stipulation within the act. Based on the final rule, the bank could receive 27 cents for a $100 debit transaction: the 21-cent base fee, plus five cents for the fraud losses and an extra one-cent to recoup investment costs for fraud-prevention measures. This final proposal will reduce interchange revenue to the banks and credit unions nearly 50% or $10 billion annually. Exemptions from the Dodd-Frank Act Despite exempting financial institutions with assets less than $10 billion, any reduction of interchange imposed on the larger banks by the Dodd-Frank Act will pressure smaller midtier banks and credit unions to comply in order to compete. Community banks and credit unions argue that the exemption will allow retailers to discriminate against consumers carrying debit cards issued by community banks or credit 3
unions. Most small issuers use a card processor or agent bank to manage their debit transactions. The cards they issue carry the six-digit bank identification number (BIN) of the small bank s partner. Most acquirers and networks use a shared BIN process to reduce costs and to match complex interchange rate schedules. The BIN identifies the institution to the merchant and potentially places smaller institutions at a competitive disadvantage if they charge a higher interchange fee because of the asset exception. If smaller institutions are deprived of interchange income, midtier community banks and credit unions will potentially exit the debit card market. This will result in larger banks attempting to serve the 100 million midtier and credit union consumers. Less competition and reduced interchange income could also result in higher costs for consumers who hold credit and debit cards in the form of annual fees and higher interest rates. Overdraft Protection To improve debit card revenues and to fund reward programs as well as to improve the consumer experience at the point of sale, retail bankers and credit unions implemented overdraft protection. Positioning overdraft as a protection for the consumer that prevents the embarrassment of a transaction being declined at the point of sale, debit card issuers authorized overdraft approval but charged a fee for the privilege. Overdraft policies varied by institution, but on average the fee amount per transaction was $35 regardless of the amount overdrawn. Because debit cards are used frequently for everyday purchases at convenience stores, a consumer could be charged multiple overdraft fees amounting to significantly more than the value of the overdraft amounts. Overdraft fees quickly became a popular revenue item for the banks and credit unions. They soon attracted the attention of legislators and regulators, however. Fees account for approximately 5% of total retail bank revenue and approximately 10% of credit union revenue. Overdraft Revenue Loss The federal government reacted to large numbers of consumer complaints about excessive overdraft fees. Recent changes to Regulation E will reduce revenue from overdraft income. The Federal Reserve estimated that 2009 overdraft fee revenue from all sources was $37 billion, approximately $15 billion of which was associated with ATM and one-time debit card transactions. On November 12, 2009, the Federal Reserve Board published changes to Regulation E that became effective July 1 for new accounts/members and August 15, 2010 for existing accounts/members. Regulation E prescribes rules for solicitation and issuance of electronic fund transfers (EFT) for debit cards. The regulation governs consumer liability for unauthorized transfers and requires financial institutions to disclose annually the terms and conditions of EFT services. The changes affect the ability of financial institutions to charge a fee for the payment of overdrafts that result from ATM transactions or one-time debit card transactions. Under the new rule, before a financial institution can impose a fee for paying an overdraft for an ATM transaction or one-time debit card transaction, it must: Send the consumer a notice describing the institution's overdraft service Give the consumer a reasonable opportunity to affirmatively consent (opt in) to the service 4
Obtain the consumer's affirmative consent Provide the consumer with confirmation, including notice of the right to revoke Consumer Financial Protection Bureau Midtier banks and credit unions with assets less than $10 billion are exempt from direct supervisory control by the Consumer Financial Protection Bureau (CFPB). However, they will continue to be supervised by their current agency. Nevertheless, all banks are required to comply with any new rules the CFPB implements. Compliance costs will increase operating expenses for all institutions. The impact on smaller institutions will be significant because they are not easily able to absorb the increases in their already decreased profit margins. Recommendations for Credit Unions and Midtier Community Banks Credit unions and midtier community banks serve more than 100 million consumers. The two groups share common business attributes. Both tend to support consumers in their network of branches, which typically, although not exclusively, are domiciled within one state and serve both businesses and consumers. Both have strong connections to the communities they serve. Credit unions and community banks also share common challenges to adapt their business to ensure compliance with the new regulatory rules, increased competition, and changing consumer purchase and payment behavior. Analysis by TowerGroup reveals that midtier community banks and credit unions can compensate for the expected reduction in debit card revenues. The first step is to shift marketing emphasis away from debit cards and focus instead on other financial products. Spreading revenue across several financial products rather than depending on a concentration of revenue in one product like a debit card distributes and reduces the overall financial risk to the institution. Deepening the relationship the institution has with a household and providing a greater number of products to the consumer increases loyalty, reduces attrition, and increases profits. TowerGroup recommends a marketing strategy that promotes multiple financial products yet promotes the credit card ahead of the debit card because it is the more profitable product. The US economy is making slow and modest improvement but there are signs that card issuers are increasing their credit card marketing efforts to increase their revenue. New credit card solicitation volume increased in second quarter 2011 from first quarter 2011 exceeding over 1 billion pieces mailed and more consumers are seeking and using credit. The Federal Reserve reported that revolving balances have increased nearly 2% through second quarter 2011 compared to annual declines in revolving balances in 2009 and 2010.. For an institution that does not have a credit card program, now is the time to launch one. Institutions that mobilize and implement a credit card strategy quickly can expect to gain market share from competitors that are slow to act. 5
Exhibit 2 Consumer Credit Demand Increasing, Lending Policies Easing (2007 July 2011) 80 60 40 20 0 Banks begin tightening credit Banks ease credit policies, consumer demand for credit cards increases -20-40 -60 Loans Cards Demand Q3 07 Q3 08 Q3 09 Q310 July Reported Demand for Consumer Loans Percent Tightening Credit Policies Source: Federal Reserve TowerGroup Exhibit 2 shows US credit trends based on the quarterly Federal Reserve Senior Officer Loan Survey on Bank Lending Practices, a report that tracks consumer demand for credit and whether banks are tightening or easing their credit lending policies. (TowerGroup has updated the trends through July 2011, the most recent Federal Reserve survey.) Recent results indicate that consumer demand for credit is increasing and bank credit policies are easing. These signs confirm that consumers are seeking credit and that market conditions are conducive to the expansion or new launch of a credit card program. Credit Card Is the Answer TowerGroup research reveals that banks with less than $1 billion in assets and credit unions in general are the market segments hit hardest financially by the recession and regulatory changes. The Federal Deposit Insurance Corporation has reported that banks with less than $1 billion in assets constitute the largest group among the banks it deems "problem banks." Midtier banks, whose assets range from $1 billion to $10 billion, and all credit unions are at a tipping point, and their future revenue and profits are at risk. Now is the time, since the economy is improving, for midtier banks and credit unions to make adjustments to reduce the percentage of revenue they derive from debit cards and increase their revenue from other products, focusing their emphasis on credit cards. Choosing an Enterprise Solution The business objective that TowerGroup suggests would not replace debit cards, given that this product remains very popular with consumers, but would create an enterprise solution that leverages the business benefits of both a debit card program and a credit card program. This business model reduces the business risk of overdependence on revenue 6
from either product. TowerGroup believes the transition to increase credit card revenue will require that the institution either have a staff of credit card experts with skills in risk management, marketing, and operations or retain third-party industry experts to help manage costs and avoid the potential risk of high credit losses in this weak economy. TowerGroup recommends the latter course. Approximately 74% of member banks of the Independent Community Bankers of America (ICBA) currently offer their consumer accounts a credit card. Approximately 70% of ICBA members that focus on business accounts offer business credit cards. Approximately 10% of midtier community banks' 2010 gross revenue was generated from credit card programs. Because the midtier banks have a high concentration of both consumer and business credit cards, transitioning away from revenue dependence on debit card will be easier than starting a credit card program from scratch. Approximately 50% of credit unions offer credit cards to their members; these accounts represented over 6% of outstanding loans at the end of first quarter 2011.. Credit cards produce approximately 6% of total credit union gross revenues. Credit unions with assets exceeding $1 billion generated approximately 5% of their total gross revenues from credit cards in 2009. As the asset size of the credit unions decreased, a larger percentage of gross revenues came from credit cards. Institutions that do not have a credit card program or that choose to increase their revenue from an existing program are encouraged to retain expert assistance to complete this task. Developing the internal staff proficiency necessary to manage a successful credit card program requires significant investments in both time and money. This decision will reduce the product's time to market and save the institution money. More Revenue The Credit Card Accountability Responsibility and Disclosure Act of 2009 (the CARD Act) has reduced pricing flexibility for credit card issuers, thus altering the credit card profitability business model. However, with a revised business model, credit card products still have a larger profit margin than debit card products. Banks and credit unions are concerned that the Consumer Financial Protection Bureau will further erode bank card profit margins with new regulations. However, the shift in the balance of power in the US House of Representatives resulting from the November 2010 elections has slowed the momentum of new consumer legislation. Retail bankers can expect higher revenues on equivalent sales volume from a credit card program than from a debit card program, provided they control credit losses and fraud losses. TowerGroup estimates that the interchange rate for an average consumer credit card $100 purchase is 2% compared to 27 cents for an equivalent purchase via debit card. In addition, institutions can benefit from offering business credit cards, which provide higher interchange rates than consumer cards. Not only do business cards benefit the issuer, but they also include product features for reporting that track and manage card usage to manage expenses. These features will appeal to the business segment that is experiencing difficulty accessing traditional lines of credit due to tighter bank credit policies for such products. Revenue-Enhancing Features of Credit Cards The revolving feature of a credit card not only is convenient for the consumer but also delivers additional revenue to the issuer. Issuers expect that consumers will at least 7
occasionally revolve their balances and pay interest on the balance due. Unless tied to a line of credit or an equivalent product, the standard debit card does not offer a revolving feature. Generally, a revolving line of credit linked to a debit card will have a higher interest rate than a credit card. Therefore, the consumer who uses a credit card rather than a line of credit to revolve a balance benefits by paying less interest when revolving the equivalent dollar amount on a credit card. A second source of credit card revenue is fees. The credit card issuer anticipates an occasional late payment, for which the issuer charges the a late fee as a penalty. The Federal Reserve reported in October 2011 that the average interest rate for a credit card was over 14.99%. The average community bank and credit union credit card portfolio revolves over 65% of its outstanding balances. Credit Card Product Solutions New regulations have negatively affected debit and credit card profits. The CARD Act has regulated new limitations to credit card pricing and risk management. These changes do create new business challenges, but credit cards remain a profitable and valuable bank product. Product Designs The recession has changed consumer attitudes about credit. Consumers are deleveraging themselves of debt. Debit cards remain popular with consumers, and issuers must incorporate those features into their marketing and credit card designs. For example, the Discover Card, Citibank, and Chase all offer credit card products that reward responsible use of credit. Encouraging the responsible use of credit is a marketing theme that resonates with consumers, and this concept should be included in credit card designs and marketing promotions. Enterprise Rewards A leading cause of account attrition within the retail bank is inferior or inadequate choices in reward products. Retail banks responded to this problem by implementing enhanced reward programs. However, recent negative business conditions have limited the expansion of debit rewards. Therefore, TowerGroup believes that this limitation poses a risk of increased attrition for retail banks and credit unions. One solution to reduce the expense of rewards programs yet continue provide a superior reward program is to combine the reward structure to include multiple products. Rewarding usage of both a debit card and a credit card in one rewards program enables the institution to leverage this advantage to create an enterprise rewards solution similar to the Citibank Thank You Rewards program. TSYS offers enterprise rewards through its TSYS Loyalty and Prepaid subsidiary. Both offerings incorporate multiple retail products. Merchant-funded rewards, which are also gaining popularity with the banks and consumers, exemplify another solution for both banks and credit unions. Conclusions Passage of the Dodd-Frank Act and the Durbin amendment combined with changes to Regulation E will significantly reduce current and future gross revenues for debit card 8
issuers. Retail banks and credit unions must adjust their business strategies to compensate. Financial institutions must diversify their product offerings and avoid dependence on one product. Debit card products remain popular with consumers but will be significantly less profitable to issuers because of regulatory changes. Credit cards provide the same features as debit cards and are the logical alternative to debit cards. The US economy is improving, and consumer demand for credit is increasing. Now is the time for banks and credit unions to mobilize their business efforts and rejuvenate their credit card programs. TSYS commissioned TowerGroup to conduct independent research and analysis focusing on credit card issuing by small to mid-tier banks and credit unions. The content of this report is the product of TowerGroup and is based on independent, unbiased research not tied to any vendor product or solution. Although every effort has been taken to verify the accuracy of this information, neither TowerGroup nor the sponsor of this report can accept any responsibility or liability for reliance by any person on this research or any of the information, opinions, or conclusions set out in the report. 9