Mike Holt, PRI partner, discusses interchange income and how it’s calculated in this week’s blog.
The History of Interchange Income
Simply put, interchange is the small percentage of each credit card and debit card purchase amount that is paid to financial institutions by merchants for the privilege and convenience of accepting payments via the FI-issued cards. Interchange income got its start shortly after the first debit card appeared in the late 1960s as a method of payment. Mimicking the earlier invention of the credit card but without creating debt, debit cards represented an efficient replacement of cash and checks.
“Interchange income was originally shared to the FI to appropriately compensate them for taking the risk of covering and authorizing a transaction that quite possibly didn’t have the money to support it by the time it actually cleared the FI, and therefore, the customer’s account,” Holt said. “This and other potential fraud risks, especially those that have increased volume in direct correlation with the growth of the world’s digital evolution, make interchange income and its protection for the industry an absolute necessity.”
How is Interchange Income Calculated?
Interchange fees and pay rates are set and distributed by card processing networks and are the largest component of the overall fees that merchants pay. Both the issuer and acquirer pay transaction fees to Visa or Mastercard for the processing and distribution of the interchange. Interchange has a complex pricing structure which is determined by many factors such as the merchant’s geographic region, the purchase category, the annual spending size of the accepting merchant, the type of transaction authorized, the type of card presented, and even whether the card was swiped at a physical location or the purchase was completed online, known as card-not-present (CNP).
And so, it becomes quite clear that interchange income is very complex and became more so in 2012 with the passage of the Durbin amendment, which was part of the 2010 Dodd-Frank financial reform legislation. Banks with more than $10 billion in assets were now required to only earn debit card interchange fees that are “reasonable and proportional to the actual cost” of processing the transaction. The law also gave the Federal Reserve the power to regulate and set maximum debit card interchange fees. Further, with the Durbin Amendment forcing FIs to provide more network routing options for the merchant acquirers, merchants were effectively given the ability to better control purchase transaction routing. This provided avenues of choice for lesser interchange share without any qualitative benefit to either side, lowering even the sub-$10 billion “exempt” FIs’ interchange income. Merchants lobbied heavily for the rule to limit debit card swipe fees. This was considered a major loss for banks, who collectively receive billions of dollars a year in income from swipe fees.
To address the pandemic-related surge in CNP activity supporting online purchases, the Fed issued a modification to Reg II, commonly referred to as “Reg II 2.0,” which took effect on July 1, 2023. The rule requires issuers to enable merchants to choose from at least two unaffiliated networks for CNP debit card purchases online or by phone. Its passage was supported by merchant groups and PIN networks and opposed by banks and credit union associations, which contended that requiring them to support PIN networks for PINless transactions would compromise transaction security and result in increasing fraud losses.
For financial institutions, the rule change promised to further squeeze interchange income.
Learn more about Reg II 2.0 and its effects in the PRI blog Reg II 2.0: It All Boils Down to PINless Transactions.
Optimizing Interchange Income for FIs
“Community banks have the ability to optimize their network stack, and that is the major way for FIs to fight back against this misguided legislation,” Holt said. “PRI can identify more issuer-friendly networks and negotiate better agreements that allow the FI to optimize the network stack – it’s the best way to enhance interchange income.”
PRI digs deeper into this optimization process in the blog Maximizing PIN Debit Card Interchange.
Interchange rates can be affected by what retail outlets are in the FI’s town. Because it’s paid on the dollar amount versus per transaction, the FI will make more in a time of inflation and heightened spending as we’ve experienced in recent years. In a time of recession when spending decreases, the interchange income will also go down and there will be a feeling of stagnation that will follow. Interchange income generally follows the economy, lagging just behind.
Just because a particular network was the right choice 10 years ago, it doesn’t mean it’s the right choice now. Rates that networks are paying to issuers vary and fluctuate often, and it’s important to stay on top of the industry trends and understand the FI’s income levels. Additionally, PIN networks are beginning to charge more fees, and they are changing fee structures to include both a flat fee AND a percentage of the dollar amount, which makes expenses higher and harder to predict.
“PRI can negotiate better terms as FIs restack their networks,” Holt said. “We educate our clients, showing them all of our models and how they’re profiting from each transaction and then we support them in how to use the models.” This is critical at a time when most financial institutions are looking to enhance sources of non-interest income. Debit card revenue is the number one deposit-based revenue and should be maximized. Knowing the ins and outs of interchange income, including how to calculate and maximize it, can make a large impact on the bottom line.
Profit Resources specializes in identifying profitability improvement areas for financial institutions through revenue growth, cost control, streamlining processes, and effective use of technology. Contact us to learn more about our personalized approach to propel growth and improve profitability.