The Federal Reserve Board’s proposed new debit card interchange rules would result in $11.8 billion in revenue evaporating from issuers’ coffers, cutting large issuers’ debit card revenue on average by 73% per transaction and making debit cards “significantly unprofitable,” a new report suggests.

The proposed rules may leave issuers with assets less than $10 billion unaffected, but the nation’s largest banks that depend more heavily on the $16.2 billion in revenue debit cards generate annually will be compelled to change their product offerings and prices to offset the lost income, according to Tony Hayes, the partner at Oliver Wyman Group who authored the Dec. 22 report.

The Fed’s proposed rules, included in the Dodd-Frank Act (see story), also prohibit payments networks and issuers from limiting the number of transaction-routing options on a debit card to a single payment brand’s network or to two or more affiliated networks.

“The proposed regulation will have massive and far-reaching consequences for retail banks,” Hayes noted in the report. “The new economics associated with operating a debit card portfolio are likely to lead to fewer rewards programs, more consumer fees and a different set of banking choices.”

Banks earn approximately 44 cents per debit card transaction, amounting to an average of $87 in annual revenue per active card, Wyman’s data show. Under the Fed’s proposed rules, that revenue would drop to about 12 cents per debit card transaction, amounting to $24 in annual revenue per active card.

For a typical $40 PIN-debit Interlink purchase, the interchange fee for retail merchants now ranges from 30 cents to 45 cents, depending on volume, while the interchange on a $40 Visa check card signature-debit transaction ranges from 37.8 cents and 56.8 cents, according to PaymentsSource calculations using Visa Inc.’s published rates. Visa controls about 80% of the signature-debit market, the more profitable of the two types of debit card transactions.

Debit card transaction volume grew at an average annual rate of 18% between 2000 and 2009, reaching 37.9 billion transactions last year and representing 35% of all noncash retail payments, according to Wyman.

Revenue from debit card transactions provides the “economic foundation” to offer mass-market free checking services, Hayes notes. If the bulk of that revenue disappears, banks will be compelled to restructure their core products and begin charging consumers fees for consumer checking accounts and other products, he suggests.

The proposed rules’ restrictions on banks’ affiliations with debit card networks hold the potential for “even greater upheaval” by forcing banks to partner with new debit card networks by Oct. 1, Hayes wrote.

Indeed, another report from Mercator Advisory Group Inc. notes that the Fed’s two network-affiliation proposals will stir up competition in the network market.

One proposal calls for issuers to operate on two unaffiliated networks without consideration of the authorization method chosen by the cardholder. For example, issuers would offer one network for PIN-debit transactions and use an unaffiliated network for signature-debit purchases, Patricia Hewitt, director of debit advisory services at the Maynard, Mass.-based consultancy, notes in her report “The Durbin Amendment: A First Analysis of the Draft Rules.” The other proposal is to offer two unaffiliated networks for each authorization method, she writes.

There are no exemptions from the affiliations rule, Hewitt says. Networks “have been both discrete and bold in their market strategies to date, but this should help them take their gloves off and begin to compete in earnest for issuers,” she notes.

Moreover, networks will have to compete on value because interchange fees will be flattened, Hewitt writes. “Those networks that have made investments in infrastructure to support more-flexible programs, better reporting, fraud control and operating efficiencies should be able to quickly take a more-leveraged position,” she says.

Oliver Wyman’s Hayes recommends that banks submit comments on the proposed rules before the Fed’s Feb. 22 deadline. The new rules are slated to go into effect July 21.

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