Visa Inc. and MasterCard Inc. may face permanent damage to the fastest-growing part of their business after the Federal Reserve proposed rules that could cut debit-card transaction fees by 90 percent.
The change, if approved by the Fed after a public comment period, would wipe out most of an estimated $15 billion in annual revenue for U.S. lenders that issue Visa and MasterCard debit cards, including Bank of America Corp., JPMorgan Chase & Co. and Wells Fargo & Co., a major Minnesota employer.
"It is negative all around," wrote Scott Valentin, an analyst at FBR Capital Markets, in a note to clients. "This significantly impacts the business model for the networks."
Visa and MasterCard, the world's biggest payment networks, plunged more than 10 percent in New York trading Thursday after the Fed proposed capping so-called interchange fees at 12 cents each. Currently, the networks charge merchants an average of 1 percent of the purchase price, regardless of cost, and pass that money along to card-issuing banks.
"These credit-card giants and banks are imposing fees that are in no relation to the actual cost of processing, and the retailers and merchants have no way to bargain or even resist these increases," U.S. Senator Richard Durbin, the Illinois Democrat who pushed for the caps, said in an interview. "This new law brings the Federal Reserve into the picture and changes that dynamic."
The Fed hasn't yet decided how to implement a rule that would require banks to let merchants choose from at least two independent debit networks for routing transactions, a change that could create more competition for MasterCard and San Francisco-based Visa.
MasterCard said the Fed proposal fails to consider "the full range of costs" that card-issuers incur to operate debit programs and that the rules would shift merchant costs to consumers.
"Experience demonstrates that consumers, not banks or payments networks, are the biggest losers as a result of this regulation," Noah Hanft, general counsel for Purchase, New York-based MasterCard, said in a statement. "This type of price control is misguided and anticompetitive."
Visa, which derives 20 percent of its revenue from U.S. debit fees, said implementing the rules would create "unintended consequences" for the industry and consumers.
"The Federal Reserve's proposal includes artificial caps on debit interchange that do not realistically reflect the value of card acceptance and do not reflect the actual costs of running a secure, reliable and efficient debit network," Will Valentine, a spokesman for San Francisco-based Visa, said in a statement.
The caps are based on information collected from debit-card issuers, payments networks and merchants about costs, the Fed staff wrote in a memo that Vice Chairman Janet Yellen prepared for the board. This approach means the Fed is unlikely to shift much when it writes the final rule, Jaret Seiberg, a financial- services policy analyst with MF Global in Washington, said in a research note.
"Substantive changes will require new evidence, which is unlikely given the amount of work the Fed has spent on this project," Seiberg said.
The Retail Industry Leaders Association, which represents companies including Wal-Mart Stores Inc., Home Depot Inc. and Target Corp., said the Fed's proposal validates the claims of merchants that the payments market is broken.
The Fed's proposal "is a step forward for the effort to bring relief to merchants and consumers," said RILA spokesman Brian Dodge.
Bankers will push lawmakers to change or eliminate the Durbin provisions they passed in July as part of the Dodd-Frank financial overhaul legislation, according to Kenneth Clayton, senior vice president and general counsel for card policy at the American Bankers Association.
"Congress needs to revisit the issue," Clayton said. "An implementation delay would be welcome."
To compensate for the lost profit, banks may eliminate rewards on debit cards and charge some customers for using them, said John McDonald, an analyst with Sanford C. Bernstein & Co., in a Dec. 15 note to clients. Fees on deposit accounts may rise and banks may promote other products that aren't covered by the regulations, such as charge cards that require consumers to pay their bills in full each month, he wrote.
"Lowering of rates by the Fed would essentially translate to a pure profit loss for most banks," McDonald said.
Debit cards have become an increasingly popular substitute for cash with consumers as credit-card issuers cut off accounts and curbed lending amid the financial crisis and recession.
U.S. consumer spending with debit cards climbed 8 percent last year to $1.45 trillion, while credit-card purchases plunged 10 percent, according to the Nilson Report, an industry newsletter. Total debit card transactions climbed 13 percent to 38.6 billion, while credit-card transactions dropped 4 percent to 22.36 billion.
The law allows the central bank to consider fraud costs incurred by lenders in determining appropriate interchange rates. The Fed staff said in its memo that it lacked enough information to make a recommendation to the board on that issue by April 21, the statutory deadline for finalizing the rules.
"The largest cost for most of our institutions in providing these services are fraud costs and fraud prevention costs," said Bill Cheney, CEO of the Credit Union National Association. "We understand the difficult position the Fed was in and we look forward to commenting urgently and actively."
While the law exempts banks with assets of less than $10 billion, including most community banks and credit unions, those institutions remain concerned that Visa and MasterCard may ultimately lower interchange rates for everyone, Cheney said.
"Setting a cap ensures that no issuer is able to receive an interchange fee at an unreasonably high level," Yellen said in the memo outlining the proposals.