WASHINGTON  — Judges for an appeals court appeared sympathetic to the Federal Reserve Board's defense of its rule capping interchange fees on debit cards, fueling hopes by bankers that the agency will beat back a legal challenge.

Retailers filed suit against the central bank's rule in November 2011, claiming that the fee set by the Fed – roughly 21 cents per transaction – was far higher than what Congress intended. In July of last year, a U.S. district court agreed with merchants that the Fed was too flexible in setting the limit for so-called "swipe fees."

But during Jan. 17 oral arguments before the U.S. Court of Appeals for the District of Columbia Circuit, the three judge panel appeared skeptical of some key parts of the retailers' positions. That included their contention that Dodd-Frank did not give the Fed discretion to include costs not specifically listed in the regulatory reform law when setting the cap.

 "You're wasting your time," Judge Harry Edwards told a lawyer representing the retailers when he outlined such a position. "None of us buy that."

To be sure, observers said it is hard to predict exactly what the court will do when it issues a ruling, which is expected this spring. Still, bankers, credit unions and other financial services industry players anxious for the Fed's rule to stay intact viewed the hearing as a good sign.

Richard Hunt, president and CEO of the Consumer Bankers Association, described the outcome of the hearing as a "positive step" in keeping the current "swipe fee."

"While we still believe this rate is too low, ultimately rational minds will prevail on this issue and we look forward to the final decision on the appellate court," Hunt said.

He was seconded by Eric Richard, general counsel and executive vice president of the Credit Union National Association.

"We are optimistic that this will result in more costs being taken into account in the setting of interchange fees than Judge Leon's decision would allow … but nothing is certain until the court actually issues it opinion," he said.

Under Dodd-Frank, the Fed was instructed to set a debit interchange limit that should be "reasonable and proportional to the cost incurred by the issuer with respect to the transaction." But the law also told the Fed not to include "other costs incurred by an issuer which are not specific to a particular debit transaction" in its calculation.

The preponderance of the hearing focused on a three judge panel inquiring how the Fed determined what costs it included in setting the cap versus others it excluded, such as overhead and card production.

"Help me understand how the board distinguished between those that it included and those it didn't," said Judge David Tatel.

Regulators agreed to allow costs such as labor, computer software and hardware, network processing fees and fraud losses to be included as part of its fee calculation based on their interpretation of the law.

Katherine Wheatley, the Fed's associate general counsel, said the agency opted to exclude costs tied to card production because, like check transactions, banks cannot obtain reimbursements in the clearing system.

The panel also probed the Fed's attorney to understand the board's decision not to explicitly explain incremental costs in its rule.

Judge Stephen Williams said he was "surprised" the Fed made that decision. But Wheatley said the Fed felt it "didn't have to enter that thicket and define incremental costs."

One important issue was whether the Fed could add costs to the fee beyond what Dodd-Frank specifically mentioned. Judge Tatel said it was up to the merchants to show the Fed was "unreasonable" in applying these other costs to the transactions.

Jaret Seiberg, a policy analyst with Guggenheim Securities, suggested that the court's apparent rejection of the merchant's argument "appeared to take the worst case scenario for the banks off the table." He said that could mean the ultimate swipe fee would be closer to the Fed's rule than the lower one the merchants are seeking.

Another open question left unanswered is what will happen if the judges decide the Fed made a mistake in drafting its rule.

The Fed's Wheatley stressed to the panel that the current rule must be kept in place until a final court decision is made since so many parties to the industry were relying on the law.

At the end of the August, both the Fed and merchants filed separate motions calling for a stay that would allow the agency's current interchange rule to continue to apply until the appeals process concluded.

The hearing on Jan. 17 stood in stark contrast to the lower court's view of the situation. In his July ruling, U.S. District Judge Richard Leon said the cap should be closer to the 12 cents originally proposed by the Fed. He called the final rule "utterly indefensible."

Ahead of the hearing, retailers implored the appeals panel to uphold the lower court's order in their swipe fee lawsuit.

"Instead of doing what Congress ordered, the Fed gave in to pressure from big banks – and retailers and their customers are paying the price," said Mallory Duncan, senior vice president and general counsel for the National Retail Federation. "It's time for the Fed to follow the law instead of catering to the industry it is supposed to regulate."

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