Debit Card Interchange Fees and Routing

FEDERAL RESERVE SYSTEM

12 CFR Part 235

[Regulation II; Docket No. R-1818]

RIN 7100-AG67

Debit Card Interchange Fees and Routing

AGENCY:

Board of Governors of the Federal Reserve System (Board).

ACTION:

Notice of proposed rulemaking.

SUMMARY:

Regulation II implements a provision of the Dodd-Frank Act that requires the Board to establish standards for assessing whether the amount of any interchange fee received by a debit card issuer is reasonable and proportional to the cost incurred by the issuer with respect to the transaction. Under the current rule, for a debit card transaction that does not qualify for a statutory exemption, the interchange fee can be no more than the sum of a base component of 21 cents, an

ad valorem

component of 5 basis points multiplied by the value of the transaction, and a fraud-prevention adjustment of 1 cent if the issuer meets certain fraud-prevention-standards. The Board developed the current interchange fee cap in 2011 using data voluntarily reported to the Board by large debit card issuers concerning transactions performed in 2009. Since that time, data collected by the Board every other year on a mandatory basis from large debit card issuers show that certain costs incurred by these issuers have declined significantly; however, the interchange fee cap has remained the same. For this reason, the Board proposes to update all three components of the interchange fee cap based on the latest data reported to the Board by large debit card issuers. Further, the Board proposes to update the interchange fee cap every other year going forward by directly linking the interchange fee cap to data from the Board's biennial survey of large debit card issuers. Initially, under the proposal, the base component would be 14.4 cents, the

ad valorem

component would be 4.0 basis points (multiplied by the value of the transaction), and the fraud-prevention adjustment would be 1.3 cents for debit card transactions performed from the effective date of the final rule to June 30, 2025. The Board also proposes a set of technical revisions to Regulation II.

DATES:

Comments must be received on or before February 12, 2024.

ADDRESSES:

You may submit comments, identified by Docket No. R-1818, RIN 7100-AG67, by any of the following methods:

•

Agency Website: https://www.federalreserve.gov.

Follow the instructions for submitting comments at

https://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.

•

Federal eRulemaking Portal: https://www.regulations.gov.

Follow the instructions for submitting comments.

•

Email: regs.comments@federalreserve.gov.

Include docket number in the subject line of the message.

•

Fax:

(202) 452-3819 or (202) 452-3102.

•

Mail:

Ann E. Misback, Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue NW, Washington, DC 20551.

All public comments are available from the Board's website at

https://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm

as submitted, and will not be modified to remove confidential, contact or any identifiable information. Public comments may also be viewed electronically or in person in Room M-4365A, 2001 C St. NW, Washington, DC 20551, between 9 a.m. and 5 p.m. during Federal business weekdays.

FOR FURTHER INFORMATION CONTACT:

Benjamin Snodgrass, Senior Counsel (202-263-4877) or Cody Gaffney, Senior Attorney (202-452-2674), Legal Division; or Krzysztof Wozniak, Section Chief (202-452-3878) or Elena Falcettoni, Senior Economist (202-452-2528), Division of Reserve Bank Operations and Payment Systems. For users of TTY-TRS, please call 711 from any telephone, anywhere in the United States or (202) 263-4869.

SUPPLEMENTARY INFORMATION:

I. Overview

A. Summary of Proposal

A section of the Dodd-Frank Wall Street Reform and Consumer Protection Act known as the Durbin Amendment requires the Board to establish standards for assessing whether the amount of any interchange fee received by a debit card issuer is reasonable and proportional to the cost incurred by the issuer with respect to the debit card transaction.

1

The Durbin Amendment also authorizes the Board to allow for an adjustment to such interchange fee in an amount that is reasonably necessary to make allowance for costs incurred by the debit card issuer in preventing fraud in relation to debit card transactions involving that issuer.

1

Public Law 110-203, section 1075, 124 Stat. 1376, 2068 (codified at 15 U.S.C. 1693

o

-2).

The Board implemented these and other provisions of the Durbin Amendment in 2011 and 2012 when the Board adopted Regulation II (Debit Card Interchange Fees and Routing).

2

Under the current rule, each interchange fee received by a debit card issuer for a debit card transaction that does not qualify for a statutory exemption can be no more than the sum of (i) 21 cents (the “base component”), (ii) 5 basis points multiplied by the value of the transaction (the “

ad valorem

component”), and (iii) for a debit card issuer that meets certain fraud-prevention standards, a “fraud-prevention adjustment” of 1 cent per transaction. Together, the base component and

ad valorem

component comprise the “interchange fee standards”; the base component,

ad valorem

component, and fraud-prevention adjustment comprise the “interchange fee cap.”

2

12 CFR part 235.

The Board developed the current interchange fee cap using data reported to the Board by large debit card issuers on a voluntary survey that the Board conducted during the original Regulation II rulemaking. As such, the current base component,

ad valorem

component, and fraud-prevention adjustment are based on the costs incurred by large debit card issuers in connection with debit card transactions performed in 2009. Since that time, the Board has collected data from large debit card issuers on a mandatory basis every other year, as required by the Durbin Amendment.

When the Board established the interchange fee standards in current Regulation II, the Board stated that it would, over time, adjust the interchange fee standards based on reported costs, if appropriate. Similarly, with respect to the fraud-prevention adjustment, the Board stated that it would take into account data reported by large debit card issuers in the future when considering any future revisions to the fraud-prevention adjustment. The Board also noted that lower costs should result in a lower interchange fee cap as issuers become more efficient.

The data collected by the Board from large debit card issuers since the original Regulation II rulemaking show that the costs incurred by large debit card issuers in connection with debit card transactions have changed significantly over time. In particular, the costs on which the Board based the base component have nearly halved, the issuer fraud losses on which the Board based the

ad valorem

component have fallen, and the fraud-prevention costs on

which the Board based the fraud-prevention adjustment have risen, according to key metrics of those costs.

3

As a result, the Board believes that the current interchange fee standards may no longer be effective for assessing whether, for a debit card transaction subject to the standards, the amount of any interchange fee received by a debit card issuer is reasonable and proportional to the cost incurred by the issuer with respect to the transaction. Further, the Board believes that the current fraud-prevention adjustment may not reflect an amount that is reasonably necessary to make allowance for costs incurred by the debit card issuer in preventing fraud in relation to debit card transactions involving that issuer.

3

As described in section III.A,

infra,

the costs on which the Board based the base component include transaction-processing and transaction-monitoring costs.

For these reasons, the Board proposes to update all three components of the interchange fee cap based on the latest data reported to the Board by large debit card issuers concerning transactions performed in 2021. Under the proposal, the base component would decrease from 21.0 cents to 14.4 cents, the

ad valorem

component would decrease from 5.0 basis points (multiplied by the value of the transaction) to 4.0 basis points (multiplied by the value of the transaction), and the fraud-prevention adjustment would increase from 1.0 cents to 1.3 cents. The Board determined the proposed base component using a new methodology that is informed by the cumulative data reported to the Board every other year since the original Regulation II rulemaking. This methodology targets full cost recovery over time for a significant majority of transactions across large debit card issuers through a formula that relates the base component to a key metric of issuer costs. By contrast, the Board determined the proposed

ad valorem

component and proposed fraud-prevention adjustment using generally the same methodologies used in the original rulemaking.

In addition to updating the interchange fee cap for the first time since the original rulemaking, the proposed revisions would codify in Regulation II an approach for updating the three components of the interchange fee cap every other year going forward based on the latest data reported to the Board by large debit card issuers. By directly linking the interchange fee cap to data collected by the Board from large debit card issuers every other year, the proposed approach should ensure that the interchange fee cap will reflect changes in the costs incurred by debit card issuers. As a result, the Board believes that the proposal would ensure that, to the extent practicable, (i) the interchange fee standards will be effective going forward for assessing whether, for a transaction subject to the interchange fee standards, the amount of any interchange fee received by a debit card issuer is reasonable and proportional to the cost incurred by the issuer with respect to the transaction, and (ii) the fraud-prevention adjustment will continue to reflect an amount that is reasonably necessary to make allowance for costs incurred by the debit card issuer in preventing fraud in relation to debit card transactions involving that issuer. These future updates to the interchange fee cap would be implemented in accordance with the proposed methodology and would be published without inviting public comment.

The Board has reviewed its construction of the Durbin Amendment and original analysis regarding the costs incurred by debit card issuers that the Board may consider in establishing the interchange fee standards, and believes that this prior analysis remains sound. As such, the Board does not propose any changes to the costs considered for purposes of determining the base component or the issuer fraud losses considered for purposes of determining the

ad valorem

component. The Board also does not propose to modify the fraud-prevention costs considered for purposes of determining the fraud-prevention adjustment, or the fraud-prevention standards that large debit card issuers must meet to receive the fraud-prevention adjustment.

B. Outline of This Preamble

This preamble is divided into eight sections, including this overview section I. Section II provides additional legal background for the proposal, including a detailed description of the Durbin Amendment and current Regulation II.

Section III discusses the proposed revisions to the interchange fee standards in § 235.3. The Board proposes to determine the base component and

ad valorem

component every other year based on the latest data reported to the Board by debit card issuers with consolidated assets of $10 billion or more—referred to in this preamble as “covered issuers”—on the Board's biennial Debit Card Issuer Survey. The base component would be determined using a new methodology that is informed by the cumulative data reported to the Board every other year since the original Regulation II rulemaking. Specifically, the base component would be the product of (i) the transaction-weighted average of per-transaction allowable costs (excluding fraud losses) across covered issuers based on the latest data reported to the Board, and (ii) a fixed multiplier codified in Regulation II.

4

The Board proposes a fixed multiplier of 3.7, which targets full cost recovery for 98.5 percent of covered issuer transactions over time based on the cumulative data reported to the Board by covered issuers since the initial Debit Card Issuer Survey.

5

The

ad valorem

component would be the median ratio of issuer fraud losses to transaction value among covered issuers (multiplied by the value of the debit card transaction), which is the same methodology the Board used to determine the

ad valorem

component during the original Regulation II rulemaking.

4

As described in section III.A,

infra,

the costs on which the Board based the base component include transaction-processing and transaction-monitoring costs. These costs may also be referred to as “allowable costs (excluding fraud losses)” or “base component costs.”

5

In this preamble, the term “covered issuer transactions” refers to debit card transactions performed with debit cards issued by covered issuers. By targeting full cost recovery for 98.5 percent of covered issuer transactions, the Board expects that, over time, the per-transaction allowable costs (excluding fraud losses) of around 98.5 percent of covered issuer transactions will be less than or equal to the base component. As discussed in section III.B,

infra,

the proposed approach would not guarantee that covered issuers will fully recover their allowable costs for the target percentage of covered issuer transactions in any particular year.

Initially, under the proposal, the base component would be 14.4 cents and the

ad valorem

component would be 4.0 basis points (multiplied by the value of the transaction) for debit card transactions performed from the effective date of the final rule to June 30, 2025. Going forward, the Board would determine the base component and the

ad valorem

component for debit card transactions performed during the two-year period beginning July 1, 2025, based on the data reported to the Board by covered issuers on the Board's next Debit Card Issuer Survey, and would thereafter determine these amounts for each succeeding two-year period based on data reported to the Board on future Debit Card Issuer Surveys.

Section IV discusses the proposed revisions to the fraud-prevention adjustment in § 235.4. As with the interchange fee standards, the Board proposes to determine the fraud-prevention adjustment every other year based on the latest data reported to the Board by covered issuers on the biennial

Debit Card Issuer Survey. The fraud-prevention adjustment would be the median per-transaction fraud-prevention costs among covered issuers, which is generally the same methodology the Board used to determine the fraud-prevention adjustment in 2012.

Initially, under the proposal, the fraud-prevention adjustment would be 1.3 cents for debit card transactions performed from the effective date of the final rule to June 30, 2025. Going forward, the Board would determine the fraud-prevention adjustment for debit card transactions performed during the two-year period beginning July 1, 2025, based on the data reported to the Board by covered issuers on the Board's next Debit Card Issuer Survey, and would thereafter determine the fraud-prevention adjustment for each succeeding two-year period based on data reported to the Board on future Debit Card Issuer Surveys.

Section V discusses the proposed technical revisions to Regulation II, which are generally intended to make Regulation II clearer. For example, the Board proposes to add “covered issuer” as a defined term in Regulation II and use this term throughout the regulation and the Official Board Commentary on Regulation II to refer to debit card issuers with consolidated assets of $10 billion or more.

Section VI discusses the proposed effective date for the revisions. The Board proposes that the revisions would, if adopted, take effect on the first day of the next calendar quarter that begins at least 60 days after the final rule is published in the

Federal Register.

Section VII sets forth the Board's general request for comment, as well as specific questions for feedback.

Section VIII sets forth certain regulatory analyses that the Board is required to complete under the Durbin Amendment and certain other statutes, such as the Regulatory Flexibility Act and the Paperwork Reduction Act.

II. Legal Background

A. Statutory Authority

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was enacted on July 21, 2010.

6

Section 1075 of the Dodd-Frank Act amended the Electronic Fund Transfer Act (EFTA) (15 U.S.C. 1693

et seq.

) to add a new section 920 regarding interchange fees for debit card transactions and rules for debit card and credit card transactions.

7

6

See

Public Law 111-203, 124 Stat. 1376 (2010).

7

EFTA section 920 is codified at 15 U.S.C. 1693

o

-2. EFTA section 920(c)(2) defines “debit card” to mean any card (including a general-use prepaid card), or other payment code or device, issued or approved for use through a payment card network to debit an asset account, regardless of the purpose for which the account is established, and regardless of whether authorization is based on signature, PIN, or other means. Most of EFTA section 920's requirements relate to debit card transactions—referred to in the statute and in Regulation II as “electronic debit transactions”—which are defined in EFTA section 920(c)(5) as transactions in which a person uses a debit card. This preamble uses the term “debit card transaction” interchangeably with “electronic debit transaction.” Similarly, this preamble uses the term “interchange fee” interchangeably with the statutory term “interchange transaction fee.” EFTA section 905(c)(8) defines “interchange transaction fee” as any fee established, charged, or received by a payment card network for the purpose of compensating an issuer for its involvement in an electronic debit transaction. For an overview of the debit card industry,

see

76 FR 43393, 43395-96 (July 20, 2011).

EFTA section 920(a)(2) provides that the amount of any interchange fee that an issuer may receive or charge with respect to a debit card transaction shall be reasonable and proportional to the cost incurred by the issuer with respect to the transaction.

8

EFTA section 920(a)(3) requires the Board to establish standards for assessing whether the amount of any interchange fee is reasonable and proportional to the cost incurred by the issuer with respect to the transaction. EFTA section 920(a)(4) sets forth various considerations that the Board must take into account when establishing these interchange fee standards. Specifically, the Board must consider the functional similarity between debit card transactions and checking transactions that are required within the Federal Reserve bank system to clear at par. The Board must also distinguish between (i) the incremental cost incurred by an issuer for the role of the issuer in the authorization, clearance, or settlement of a particular debit card transaction, which cost shall be considered by the Board; and (ii) other costs incurred by an issuer which are not specific to a particular debit card transaction, which costs shall not be considered by the Board.

8

“Issuer” is defined in EFTA section 920(c)(9) to mean any person who issues a debit card, or credit card, or the agent of such person with respect to such card.

Under EFTA section 920(a)(5)(A), the Board may allow for an adjustment to the interchange fee received or charged by an issuer under the interchange fee standards if such adjustment is reasonably necessary to make allowance for costs incurred by the issuer in preventing fraud in relation to debit card transactions involving the issuer, provided that the issuer complies with fraud-related standards established by the Board. The Board's fraud-related standards must, among other things, require issuers to take effective steps to reduce the occurrence of, and costs from, fraud in relation to debit card transactions, including through the development and implementation of cost-effective fraud prevention technology.

Certain issuers and debit card transactions are exempt from the interchange fee standards. EFTA section 920(a)(6) exempts any issuer that, together with its affiliates, has assets of less than $10 billion.

9

EFTA section 920(a)(7)(A)(i) exempts an interchange fee charged or received with respect to a debit card transaction in which a person uses a debit card or general-use prepaid card that has been provided to a person pursuant to a Federal, State, or local government-administered payment program, in which the person may only use the debit card or general-use prepaid card to transfer or debit funds, monetary value, or other assets that have been provided pursuant to such program. EFTA section 920(a)(7)(A)(ii) exempts an interchange fee charged or received with respect to a debit card transaction in which a person uses certain general-use prepaid cards.

10

9

For purposes of this exemption, EFTA section 920(a)(6) provides that the term “issuer” shall be limited to the person holding the asset account that is debited through a debit card transaction.

10

Specifically, EFTA section 920(a)(7)(A)(ii) exempts an interchange fee charged or received with respect to a debit card transaction in which a person uses a plastic card, payment code, or device that is (i) linked to funds, monetary value, or assets purchased or loaded on a prepaid basis; (ii) not issued or approved for use to access or debit any account held by or for the benefit of the cardholder (other than a subaccount or other method of recording or tracking funds purchased or loaded on the card on a prepaid basis); (iii) redeemable at multiple, unaffiliated merchants or service providers, or automated teller machines; (iv) used to transfer or debit funds, monetary value, or other assets; and (v) reloadable and not marketed or labeled as a gift card or gift certificate.

EFTA section 920(a)(3)(B) authorizes the Board to require any issuer or payment card network to provide the Board with such information as may be necessary to carry out the provisions of EFTA section 920(a). This provision additionally requires the Board, in issuing rules under EFTA section 920(a) and on at least a biannual basis thereafter, to disclose such aggregate or summary information concerning the costs incurred, and interchange fees charged or received, by issuers or payment card networks in connection with the authorization, clearance, or settlement of debit card transactions as

the Board considers appropriate and in the public interest.

11

11

EFTA section 920 contains various other provisions, but the proposed revisions to Regulation II discussed in this preamble would not substantively amend the provisions of Regulation II that implement these other statutory provisions. Specifically, EFTA section 920(a)(1) authorizes the Board to prescribe regulations to prevent circumvention or evasion of EFTA section 920(a). EFTA section 920(a)(8) confers upon the Board additional authority to prescribe regulations concerning network fees. EFTA section 920(b) requires the Board to prescribe regulations related to the routing of debit card transactions.

B. Regulation II

The Board adopted a final rule implementing the interchange fee standards and an interim final rule implementing the fraud-prevention adjustment in July 2011.

12

In August 2012, the Board adopted a final rule amending its interim final rule regarding the fraud-prevention adjustment.

13

These rules were codified as Regulation II.

12

Regulation II, Debit Card Interchange Fees and Routing, codified at 12 CFR part 235.

See

76 FR 43393 (July 20, 2011) (final rule); 76 FR 43477 (July 20, 2011) (interim final rule).

13

See

77 FR 46258 (Aug. 3, 2012).

Section 235.3(a) of Regulation II implements EFTA section 920(a)(2) by providing that the amount of any interchange fee that an issuer may receive or charge with respect to a debit card transaction shall be reasonable and proportional to the cost incurred by the issuer with respect to the transaction. Section 235.3(b) implements EFTA section 920(a)(3) by providing that an issuer complies with the requirements of § 235.3(a) only if each interchange fee received or charged by the issuer for a debit card transaction is no more than the sum of (i) 21 cents and (ii) 5 basis points multiplied by the value of the transaction.

14

These amounts, together with any fraud-prevention adjustment permitted under § 235.4, comprise the interchange fee cap.

14

The Official Board Commentary on Regulation II, found in appendix A to part 235, refers to these amounts as the “base component” and the “

ad valorem

component,” respectively.

Section 235.4 implements the fraud-prevention adjustment permitted by EFTA section 920(a)(5). Specifically, § 235.4(a) allows an issuer that meets the fraud-prevention standards enumerated in § 235.4(b) to receive or charge an amount of no more than 1 cent per transaction in addition to any interchange fee it receives or charges in accordance with § 235.3. Section 235.4(b) provides that to be eligible to receive or charge the fraud-prevention adjustment, an issuer must develop, implement, and periodically review fraud-related policies and procedures meeting certain requirements. Section 235.4(c) provides that to be eligible to receive or charge a fraud-prevention adjustment, an issuer must annually notify its payment card networks that it complies with the fraud-prevention standards in § 235.4(b). Section 235.4(d) sets forth rules for when an issuer, or the appropriate agency, determines that the issuer is not eligible to receive or charge a fraud-prevention adjustment.

15

15

The appropriate agency for a particular entity is determined pursuant to § 235.9 and EFTA section 918 (15 U.S.C. 1693

o

). For example, the Board is the appropriate agency with respect to member banks of the Federal Reserve System (other than national banks), branches and agencies of foreign banks (other than federal branches, federal Agencies, and insured state branches of foreign banks), commercial lending companies owned or controlled by foreign banks, and organizations operating under section 25 or 25A of the Federal Reserve Act.

Section 235.5 implements the statutory exemptions from the interchange fee standards. Section 235.5(a) generally provides that the interchange fee standards do not apply to an interchange fee received or charged by an issuer with respect to a debit card transaction if the issuer, together with its affiliates, has assets of less than $10 billion as of the end of the calendar year preceding the date of the transaction and holds the account that is debited. Section 235.5(b) implements the statutory exemption for government-administered payment programs. Section 235.5(c) implements the statutory exemption for certain reloadable prepaid cards.

Section 235.8 implements the data collection provisions in EFTA section 920(a)(3)(B). Specifically, § 235.8(a) provides that each issuer that is not otherwise exempt from the requirements of this part under § 235.5(a) and each payment card network shall file a report with the Board.

16

Section 235.8(b) provides that each entity required to file a report with the Board shall submit data in a form prescribed by the Board for that entity. Pursuant to this authority, the Board collects information from debit card issuers with consolidated assets of $10 billion or more every other year through the Debit Card Issuer Survey.

17

The Board also collects information from payment card networks every year through the Payment Card Network Survey.

18

The Board has published a summary of findings from these two surveys on a biennial basis since 2013, consistent with EFTA section 920(a)(3)(B).

19

The Board's most recent biennial report was published concurrently with this proposal.

20

16

The reference to “the requirements of this part” in § 235.8(a) is erroneous, as debit card issuers that qualify for the exemption in § 235.5(a) are

not

exempt from the requirements of § 235.7 (network exclusivity and debit card transaction routing) or § 235.8(c) (record retention). As described in section V,

infra,

the Board proposes a technical correction to fix this error.

17

See

FR 3064a.

18

See

FR 3064b.

19

See

Board of Governors of the Federal Reserve System,

2011 Interchange Fee Revenue, Covered Issuers Costs, and Covered Issuer and Merchant Fraud Losses Related to Debit Card Transactions

(Mar. 5, 2013),

https://www.federalreserve.gov/paymentsystems/files/debitfees_costs_2011.pdf.

20

The Board's reports may be found on the Board's website.

See

Board of Governors of the Federal Reserve System,

Regulation II (Debit Card Interchange Fees and Routing): Reports and Data Collections, https://www.federalreserve.gov/paymentsystems/regii-data-collections.htm.

Additionally, on an annual basis, the Board publishes average interchange fees by network.

See

Board of Governors of the Federal Reserve System,

Regulation II (Debit Card Interchange Fees and Routing): Average Debit Card Interchange Fee by Payment Card Network, https://www.federalreserve.gov/paymentsystems/regii-average-interchange-fee.htm.

Appendix A to part 235 is the Official Board Commentary on Regulation II. In general, the commentary provides background material to explain the Board's intent in adopting a particular part of the regulation and examples to aid in understanding how a particular requirement is to work.

21

21

Other provisions of Regulation II implement provisions of EFTA section 920 that are not directly relevant to the proposed revisions discussed in this preamble. Specifically, § 235.6 prohibits circumvention or evasion of the interchange fee restrictions in Regulation II and prohibits an issuer from receiving net compensation from a payment card network within a calendar year. Section 235.7 sets forth rules related to network exclusivity and the routing of debit card transactions. To address certain issues related to the routing of card-not-present debit card transactions, the Board recently revised § 235.7 and the commentary thereto, with an effective date of July 1, 2023.

See

87 FR 61217 (Oct. 11, 2022).

III. Proposed Revisions to the Interchange Fee Standards (§ 235.3)

A. Background

As described above, EFTA section 920(a)(3) directs the Board to establish standards for assessing whether the amount of any interchange fee is reasonable and proportional to the cost incurred by the issuer with respect to the transaction. To fulfill this statutory mandate, the Board (i) defined the costs incurred by debit card issuers that the Board considers, consistent with the statute (referred to herein as “allowable costs”), and (ii) established standards for assessing interchange fees relative to allowable costs. A brief overview of how the Board developed the interchange fee standards in current § 235.3 follows.

1. Allowable Costs

EFTA section 920(a)(4)(B) requires the Board, in establishing interchange fee standards, to distinguish between (i) the incremental cost incurred by an issuer

for the role of the issuer in the authorization, clearance, or settlement of a particular debit card transaction, which cost shall be considered by the Board; and (ii) other costs incurred by an issuer which are not specific to a particular debit card transaction, which costs shall not be considered by the Board.

22

When the Board adopted current § 235.3 in 2011, the Board identified a third category of costs that the Board is permitted, but not required, to consider: costs incurred by an issuer that are specific to a particular debit card transaction but are not incremental costs related to a debit card issuer's role in authorization, clearance, and settlement.

23

22

EFTA section 920(a)(4)(a) also requires the Board to consider the functional similarity between debit card transactions and checking transactions that are required within the Federal Reserve bank system to clear at par. For a discussion of this requirement, see section VIII.B,

infra.

23

The Board observed in 2011 that EFTA does not define “other costs incurred by an issuer which are not specific to a particular electronic debit transaction,” which the Board is prohibited from considering.

See

76 FR 43393, 43426 (July 20, 2011). In 2010, the Board initially proposed to exclude costs that could not be attributed to any identified debit card transaction (referred to as “fixed costs” in the proposal), even if those costs were specific to effecting debit card transactions as a whole.

See

75 FR 81721, 81735-36 (Dec. 28, 2010). After considering public comments, the Board at the final rule stage interpreted the category of prohibited costs to include only those costs that are not incurred in the course of effecting any debit card transaction.

See

76 FR at 43426. Further, the Board noted that the statute is silent on those costs that are not incremental costs related to a debit card issuer's role in authorization, clearance, and settlement, but that are specific to a particular debit card transaction.

See id.

The Board determined that EFTA section 920(a)(4)(B) did not specifically instruct the Board to consider this third category of costs but did not prohibit their consideration.

See id.

The Board's interpretation of the statute was upheld by the U.S. Court of Appeals for the District of Columbia Circuit.

See NACS

v.

Board of Governors of the Federal Reserve System,

746 F.3d 474, 488-89 (D.C. Cir. 2014).

See also

80 FR 48684 (Aug. 14, 2015) (clarifying the treatment of transaction-monitoring costs, as required by the D.C. Circuit).

Using this framework, the Board defined the allowable costs that the Board considered in establishing the interchange fee standards set forth in § 235.3. For reasons explained in the preamble accompanying the 2011 final rule, allowable costs comprise (i) transaction-processing costs, including fixed and variable authorization, clearance, and settlement costs, network processing fees (

e.g.,

switch fees), and the costs of processing chargebacks and other non-routine transactions; (ii) transaction-monitoring costs; and (iii) issuer fraud losses.

24

Allowable costs do not include other costs incurred by debit card issuers in connection with their debit card programs, such as corporate overhead and account-relationship costs, general debit card program costs (

e.g.,

card production and delivery costs, marketing costs, and research and development costs), or costs of non-sufficient funds handling, cardholder rewards, and cardholder inquiries.

25

24

See

76 FR at 43429-31.

25

See

76 FR at 43427-29.

The Board has reviewed its construction of the statute and prior analysis regarding the allowable costs that the Board considered in establishing the interchange fee standards, and believes that this prior analysis remains sound. As such, the Board does not propose any changes to the allowable costs considered for purposes of the interchange fee standards.

As described below, the Board established the base component based on transaction-processing and transaction-monitoring costs, but separately assessed issuer fraud losses through the

ad valorem

component. Transaction-processing and transaction-monitoring costs are collectively referred to in this preamble as “base component costs.”

2. Interchange Fee Standards

For reasons explained in the preamble accompanying the 2011 final rule, the Board adopted a uniform, transaction-level standard that, subject to any fraud-prevention adjustment that a covered issuer may be permitted to receive or charge under § 235.4, establishes the maximum permissible interchange fee that a covered issuer may receive for a debit card transaction subject to the interchange fee standards.

26

This maximum interchange fee is the sum of a base component and an

ad valorem

component.

26

See

76 FR at 43431-35.

To determine the base component, the Board referred to the data that the Board had collected shortly after the Dodd-Frank Act was signed into law via a voluntary survey of covered issuers concerning debit card transactions performed in the 2009 calendar year.

27

Based on these data, the Board computed the per-transaction base component costs of each covered issuer that reported such costs by summing the base component costs reported by the covered issuer and dividing this sum by the total number of debit card transactions reported by the covered issuer. The Board then arranged these per-transaction costs in ascending order from lowest- to highest-cost covered issuer.

28

27

See

Board of Governors of the Federal Reserve System,

2009 Debit Card Issuer Survey

(Sep. 13, 2010),

https://www.federalreserve.gov/paymentsystems/files/payment_card_network_survey_20100920.pdf.

The survey respondents included 66 covered issuers, representing about 57 percent of total debit card transactions by volume and 60 percent of total debit card transactions by value in 2009. However, because some covered issuers did not respond to the voluntary survey, the proportion of total debit card transactions performed in 2009 that are attributable to covered issuers (including respondents and non-respondents) was greater than 57 percent (by volume) and 60 percent (by value). The Board discussed preliminary summary findings from this survey in its 2010 proposal to establish interchange fee standards.

See

75 FR at 81724-26. The Board subsequently published a report summarizing the data collected from the survey.

See

Board of Governors of the Federal Reserve System,

2009 Interchange Fee Revenue, Covered Issuer Costs, and Covered Issuer and Merchant Fraud Losses Related to Debit Card Transactions

(June 2011),

https://www.federalreserve.gov/paymentsystems/files/debitfees_costs.pdf.

28

See

76 FR at 43433.

The Board observed that this distribution of per-transaction base component costs across covered issuers was quite skewed. These costs ranged from 3 cents to 66 cents per transaction, with a considerable majority of covered issuers concentrated in the range of costs below 21 cents, and a scattered set of covered issuers having significantly higher costs above 21 cents. Further, below 21 cents, the difference between the per-transaction base component costs of adjacently ranked covered issuers was small, but at around 21 cents, the distribution showed a marked discontinuity, with base component costs varying more significantly across these higher-cost covered issuers.

The Board concluded that establishing interchange fee standards to accommodate these higher-cost covered issuers would not be reasonable or proportional to the overall cost experience of the substantial majority of covered issuers.

29

For that reason, the Board adopted a base component of 21 cents per transaction. Had that base component been in effect in 2009, approximately 80 percent of covered issuers that responded to the Board's voluntary survey would have fully recovered their base component costs.

30

29

See id.

30

In other words, for approximately 80 percent of covered issuers that responded to the Board's voluntary survey, the covered issuer's base component costs in 2009 were less than or equal to the product of 21 cents and the number of transactions involving that issuer's debit cards in 2009. However, the Board did not indicate that the Board was adopting any particular cost-recovery target across covered issuers (

i.e.,

that 80 percent of covered issuers should fully recover their base component costs) or across covered issuer transactions.

The Board recognized that issuer fraud losses are distinct from the other types of allowable costs in that the amount of a fraud loss varies with the

amount of the transaction.

31

For this reason, the Board determined that these fraud losses were best assessed through a separate

ad valorem

component. To determine the

ad valorem

component, the Board computed the ratio of issuer fraud losses to transaction value for each covered issuer that reported such costs in response to the voluntary survey.

32

Specifically, for each such issuer, the Board divided (i) the issuer fraud losses by (ii) the total value of the issuer's debit card transactions. The Board then sorted these ratios, expressed in basis points, in ascending order from lowest to highest.

31

See

76 FR at 43431.

32

In the preamble accompanying the 2011 final rule, the Board used the term “per-transaction fraud losses” for this metric, but the Board now believes that “ratio of issuer fraud losses to transaction value” is a more accurate description.

The resulting distribution showed that the ratio of issuer fraud losses to transaction value varied considerably among covered issuers, ranging from 0.9 to 19.6 basis points, but the distribution was not skewed like that of per-transaction base component costs. For the reasons explained in the preamble accompanying the 2011 final rule, the Board adopted an

ad valorem

component of 5 basis points of the transaction value, which corresponded to the median ratio of issuer fraud losses to transaction value among covered issuers, rounded to the nearest basis point, based on the Board's voluntary survey.

33

33

See

76 FR at 43434.

The Board described the foregoing methodologies for determining the base component and

ad valorem

component in the preamble accompanying the 2011 final rule. The Board did not, however, codify these methodologies in § 235.3. Rather, § 235.3(b) simply provides that each interchange fee received or charged by a debit card issuer for a debit card transaction shall be no more than the sum of 21 cents and 5 basis points multiplied by the value of the transaction.

B. Rationale for Proposal

When the Board established the interchange fee standards in current § 235.3, the Board stated that it would regularly collect data on the costs incurred by covered issuers in connection with debit card transactions and, over time, would adjust the interchange fee standards based on reported costs, if appropriate. The Board also noted that lower costs should result in a lower interchange fee cap as issuers become more efficient.

34

To date, the Board has not proposed or finalized any adjustments to the interchange fee standards in § 235.3.

35

34

See

76 FR at 43432.

35

In December 2022, two trade associations representing merchants submitted a rulemaking petition to the Board regarding the interchange fee standards in Regulation II. Specifically, the petitioners requested that the Board initiate a rulemaking to lower the base component from 21 cents to 9.7 cents, and eliminate or substantially reduce the

ad valorem

component and the fraud-prevention adjustment. The Board views the rulemaking petition as an additional consideration related to the proposal; however, the Board's rationale for the proposal is discussed in this section III.B.

Consistent with EFTA section 920(a)(3)(B), the Board has surveyed covered issuers on a mandatory basis every other year since the reporting requirements in § 235.8 of Regulation II were adopted. Through these biennial surveys, the Board has collected data from covered issuers concerning the costs incurred by those issuers in connection with debit card transactions performed in calendar years 2011, 2013, 2015, 2017, 2019, and 2021. The Board has reviewed the interchange fee standards in § 235.3 in light of both the most recently collected data from 2021 and the cumulative data collected from covered issuers since the original Regulation II rulemaking. As a result of this analysis, and as described below, the Board believes that revisions to the current interchange fee standards are appropriate at this time.

While the interchange fee standards have remained the same since § 235.3 was adopted, several data points show that the allowable costs incurred by covered issuers have fallen significantly since the original Regulation II rulemaking. In particular, the Board monitors one especially important metric that approximates the base component costs of the average covered issuer transaction: the transaction-weighted average of per-transaction base component costs across covered issuers.

36

That metric was 3.9 cents in 2021, which represents a decline of nearly 50 percent since 2009 (7.7 cents) and over 23 percent since 2011 (5.1 cents), the first year for which the Board collected data on a mandatory basis.

36

The Board computes the transaction-weighted average of per-transaction base component costs across covered issuers by (i) summing base component costs across covered issuers that reported these costs; and (ii) dividing this sum by the sum of the total number of debit card transactions across covered issuers that reported base component costs. The transaction-weighted average of per-transaction base component costs across covered issuers can be viewed as a broad measure of whether covered issuers collectively are becoming more or less efficient at processing debit card transactions. Specifically, this metric corresponds to the average base component costs of a debit card transaction for covered issuers as a whole. The Board believes that, for skewed distributions like the distribution of per-transaction base component costs, the transaction-weighted average is preferable to alterative metrics, such as the unweighted average across covered issuers, or a given percentile across covered issuers. In particular, the transaction-weighted average is less affected than these alternative metrics by outliers, including covered issuers with low transaction volumes but per-transaction base component costs considerably greater than the vast majority of covered issuers. Further, for skewed distributions like the distribution of per-transaction base component costs, the transaction-weighted average is preferable to the median because, unlike that metric, its value depends on all covered issuers' per-transaction base component costs, rather than only on whether such values fall above or below the median. For example, a reduction in the per-transaction base component costs of the less efficient 50 percent of covered issuers (

e.g.,

due to the adoption of a new transaction-processing technology by these issuers) would cause a decline in the transaction-weighted average but may not affect the median.

The Board also monitors issuer fraud losses, on which the Board based the

ad valorem

component. The median ratio of issuer fraud losses to transaction value among covered issuers declined by around 15 percent from 2011 (4.7 basis points, or 5.0 basis points if rounded to the nearest basis point) to 2021 (4.0 basis points).

Taken together, these declines in base component costs and issuer fraud losses have resulted in a substantial increase in the percentage of covered issuers that fully recovered their allowable costs from 2011 (61.1 percent) to 2021 (77.4 percent).

37

37

A covered issuer is considered to have fully recovered its allowable costs if the covered issuer's allowable costs in a particular year were less than or equal to the aggregate amount of interchange fees permitted under the interchange fee cap for transactions involving that issuer's debit cards in the particular year. In contrast to the increase in the percentage of covered issuers that fully recovered their allowable costs from 2011 to 2021, the percentage of covered issuer transactions for which covered issuers fully recovered their allowable costs was the same in 2021 as it was in 2011 (99.5 percent).

As a result of the significant decline in the allowable costs incurred by covered issuers since 2009, the Board believes that the current interchange fee standards in § 235.3 may no longer be effective for assessing whether, for a debit card transaction subject to the interchange fee standards, the amount of any interchange fee received or charged by a debit card issuer is reasonable and proportional to the cost incurred by the issuer with respect to the transaction, as required by EFTA section 920(a)(2). As such, the Board believes it is necessary to revise the interchange fee standards to reflect the decline since 2009 in base component costs and the decline over time in the ratio of issuer fraud losses to transaction value for covered issuers.

Furthermore, the Board believes that, as much as practicable, the base component and

ad valorem

component should be updated regularly and

predictably to reflect changes in the allowable costs incurred by covered issuers as those changes occur. Such an approach would avoid long periods during which the interchange fee standards may not be effective for assessing whether, for a debit card transaction subject to the interchange fee standards, the amount of any interchange fee received or charged by a debit card issuer is reasonable and proportional to the cost incurred by the issuer with respect to the transaction. In addition, directly linking the interchange fee standards to the data reported to the Board by covered issuers on the Board's biennial survey would capture changes in allowable costs as quickly as practicable. Further, the Board believes that the patterns observed in the cumulative data collected by the Board since the original rulemaking, described further below, are consistent over time and thus support the establishment at this time of a repeatable process that directly links the interchange fee standards to the data reported on the Debit Card Issuer Survey. Finally, this approach would create predictability for the debit card industry regarding how and when updates to the interchange fee cap would occur.

For these reasons, and as described below, the Board proposes to determine the base component and

ad valorem

component in § 235.3 every other year based on the latest data reported to the Board by covered issuers. The Board believes that, under this approach, the interchange fee standards in § 235.3 will be effective going forward for assessing whether, for a debit card transaction subject to the interchange fee standards, the amount of any interchange fee received or charged by a debit card issuer is reasonable and proportional to the cost incurred by the issuer with respect to the transaction.

38

38

In lieu of directly linking the interchange fee standards to data from the Board's biennial survey of covered issuers going forward, the Board could consider adopting a one-time update to the base component and

ad valorem

component in § 235.3. Following such an approach, the Board would continue to monitor changes in the allowable costs incurred by covered issuers and would propose further updates to the base component and

ad valorem

component in the future, if appropriate. However, such ad hoc updates to the base component and

ad valorem

component would not be predictable, and they could result in periods during which the interchange fee standards may not be effective for assessing whether, for a debit card transaction subject to the interchange fee standards, the amount of any interchange fee received or charged by a debit card issuer is reasonable and proportional to the cost incurred by the issuer with respect to the transaction.

The Board also proposes a new methodology for determining the base component. As described above, in 2011, the Board adopted a base component of 21 cents per transaction. The Board selected 21 cents because that value was the site of a clear discontinuity in the distribution of per-transaction base component costs across covered issuers, arranged from lowest- to highest-cost covered issuer, for debit card transactions performed in 2009.

39

The Board has reviewed the distribution of per-transaction base component costs across covered issuers, arranged from lowest- to highest-cost covered issuer, from each biennial survey of covered issuers conducted since Regulation II was adopted. In some survey years, the distribution contained no clear discontinuity; in other survey years, there were multiple apparent discontinuities. In addition, in some cases, the amount corresponding to a particular discontinuity did not reflect the overall trend in the transaction-weighted average of per-transaction base component costs across covered issuers. For these reasons, the Board believes that the original methodology that the Board used to determine the base component by reference to a clear discontinuity in the distribution of per-transaction base component costs across covered issuers, arranged from lowest- to highest-cost covered issuer, is not appropriate for determining the base component at this time and, going forward, would not facilitate the regular and predictable updates to the interchange fee standards that the Board proposes.

39

As described above, the Board noted that, had the current base component been in effect in 2009, approximately 80 percent of covered issuers would have fully recovered their base component costs through the base component. However, the Board did

not

indicate that the Board was selecting a cost-recovery target of 80 percent of covered issuers (or any other cost-recovery target across covered issuers or covered issuer transactions) and did not codify in Regulation II an approach for updating the base component to reflect any particular cost-recovery target.

Instead, as described below, the Board proposes to determine the base component as a function of the transaction-weighted average of per-transaction base component costs across covered issuers. Under this methodology, any change in the base component costs of the average covered issuer transaction would result in a

proportional

change to the base component. As such, this methodology will ensure that the maximum interchange fee that a covered issuer may receive will be proportional to the base component costs incurred by covered issuers with respect to the average covered issuer transaction, consistent with the Durbin Amendment. Combined with the Board's proposal to determine the base component every other year based on the latest data reported to the Board by covered issuers, this approach is designed to ensure that, to the extent practicable, any interchange fee that a covered issuer receives or charges will remain proportional to the costs incurred by covered issuers with respect to the average debit card transaction over time.

40

40

In 2011, the Board rejected a mathematical interpretation of the word “proportional” that would have

required

a constant proportion between allowable costs and interchange fees.

See

76 FR 43393, 43423 (July 20, 2011). The Board continues to believe that the statute requires only that the interchange fees must have a relationship to allowable costs, as the Board stated in 2011.

See id.

Determining the base component as a fixed multiple of the transaction-weighted average of per-transaction base component costs across covered issuers is thus consistent with the statute, and is desirable because it will enable the Board, going forward, to determine the base component based on the latest data reported to the Board by covered issuers.

More specifically, the Board proposes to determine the base component as the product of a fixed multiplier and the transaction-weighted average of per-transaction base component costs across covered issuers. Under this formula, the fixed multiplier would be codified in Regulation II and would remain constant. The fixed multiplier would correspond to a target selected by the Board for a

reasonable

percentage of covered issuer transactions for which covered issuers should fully recover their base component costs over time, consistent with the Durbin Amendment.

Consistent patterns that the Board has observed in the data collected from covered issuers since 2009 related to per-transaction base component costs make it possible to derive such a formula. Specifically, while the transaction-weighted average of per-transaction base component costs across covered issuers has declined significantly since the original Regulation II rulemaking, the shape of the distribution of per-transaction costs across covered issuer transactions has not changed markedly between the data collections.

41

Importantly, this particular shape can be well-characterized by a probability

distribution with a key property: the value of per-transaction base component costs at a target percentile across covered issuer transactions is a multiple of the transaction-weighted average of per-transaction base component costs across covered issuers.

42

The stability of the shape of the distribution over time means that the Board can identify a fixed multiplier that, when multiplied by the transaction-weighted average of per-transaction base component costs in each year, should yield full cost recovery for the target percentage of covered issuer transactions over time.

43

41

The Board generates the distribution of per-transaction base component costs across covered issuer transactions as follows. For each covered issuer that reported base component costs, the Board first determines the per-transaction base component costs of the covered issuer by (i) summing the base component costs reported by the covered issuer and (ii) dividing this sum by the total number of debit card transactions reported by the covered issuer. The Board then assigns this result to each of the covered issuer's transactions. Finally, the Board arranges the per-transaction base component costs of all covered issuer transactions in ascending order from lowest- to highest-cost covered issuer transaction.

42

In particular, the data on per-transaction base component costs across covered issuer transactions, arranged from lowest- to highest-cost covered issuer transaction, for each year closely approximates the Weibull distribution. The Weibull distribution, commonly used in social sciences and engineering, has the property that the value of the distribution at a particular percentile is a fixed multiple of the average value of the distribution. The Weibull distribution captures a number of key features of the data on covered issuer transactions, including the existence of a small number of high-cost transactions associated with relatively low-volume, high-cost covered issuers.

43

A particular Weibull distribution is described by two parameters: (i) its scale, which determines the magnitude of the values along the distribution; and (ii) its shape, which determines the degree to which the distribution is skewed to one side. The Board's analysis determined that the consistent patterns in the distribution of per-transaction base component costs across covered issuer transactions for each set of survey data collected since 2009 can be best captured using the Weibull distribution with (i) a scale parameter that is proportional to the transaction-weighted average of per-transaction base component costs across covered issuers for each year, and (ii) a shape parameter that is stable over time. The Board's analysis did not find a statistically significant improvement in the fit of the Weibull distribution to the data when the shape parameter is allowed to differ across years.

The stability of the shape of the distribution observed in data collected from covered issuers since 2009 suggests that there are features inherent to the covered issuer segment of the debit card market that persist over time. For this reason, the Board believes that, in future data collections, the distribution of per-transaction base component costs across covered issuer transactions will continue to exhibit a similar shape. Thus, the fixed multiplier derived from the cumulative data collected by the Board since 2009 should continue to yield full cost recovery over time for the target percentage of covered issuer transactions going forward.

Although the proposed fixed multiplier would correspond to a target percentage of covered issuer transactions for which covered issuers should fully recover their base component costs over time, the proposed approach would not guarantee this precise level of cost recovery in any particular year. Rather, in some years, covered issuers may fully recover their base component costs for more than the target percentage of covered issuer transactions; in other years, covered issuers may fully recover their base component costs for less than the target percentage of covered issuer transactions. Over time, however, the Board expects the actual cost recovery of covered issuer transactions to be close to the Board's cost-recovery target.

44

The Board intends to monitor over time the actual cost recovery of covered issuer transactions relative to the Board's cost-recovery target, and in the future may seek comment on potential adjustments to improve the proposed methodology for determining the base component, if appropriate. For example, adjustments to the proposed methodology may be appropriate in the event of fundamental changes to the debit card industry that significantly change the shape of the distribution of per-transaction base component costs across covered issuer transactions relative to the consistent patterns the Board has observed in the cumulative data collected from covered issuers since 2009.

44

The Board assesses how close actual cost recovery is to the cost-recovery target for a particular fixed multiplier by evaluating, for each year, the extent to which actual cost recovery would have diverged from the target had the relevant base component been in effect, and then considering the average deviation over time resulting from these calculations. Specifically, the Board first calculates the difference between the cost-recovery target and the percentage of covered issuer transactions performed in 2009 for which covered issuers would have fully recovered their base component costs if, in 2009, the base component had been the product of (i) the transaction-weighted average of per-transaction base component costs across covered issuers in 2009, and (ii) the fixed multiplier. Second, the Board performs the same calculation for transactions performed in 2011. The Board then takes the simple average of the differences calculated for each year (

i.e.,

for 2009 and 2011). Third, the Board repeats this process for transactions performed in 2013, 2015, 2017, 2019, and 2021, in each case taking the average of the differences calculated for each year so far. These averages represent the extent to which actual cost recovery would have diverged over time from the target had the relevant base components been in effect.

For the fixed multiplier that the Board proposes (

i.e.,

3.7, as described below), using the measure of closeness described above, the Board found that the actual cost-recovery rate drew nearer to the target cost-recovery rate with each subsequent data collection that was incorporated into the Board's analysis. In other words, the simple average of the differences for 2009-13 transactions improved on that for 2009-11 transactions, which improved on the difference for 2009, and so on. This result suggests that, while for a particular data collection the actual cost-recovery rate may diverge from the target cost-recovery rate, over time actual cost recovery is likely to be close to the cost-recovery target.

To ensure that, for a debit card transaction subject to the interchange fee standards, the amount of any interchange fee received or charged by a debit card issuer is reasonable, the Board proposes a cost-recovery target of 98.5 percent of covered issuer transactions, which corresponds to a fixed multiplier of 3.7 based on the cumulative data collected from covered issuers since 2009. The Board believes that this cost-recovery target, and the base component that would result from multiplying this fixed multiplier and the transaction-weighted average of per-transaction base component costs, is reasonable because it would allow covered issuers to fully recover their base component costs over time for a significant majority of covered issuer transactions. At the same time, this target acknowledges that full cost recovery for the highest-cost covered issuer transactions would not be reasonable.

45

45

In 2011, the Board stated that the term “reasonable” implies that, above some amount, an interchange fee is not reasonable, and noted that common definitions of the term “reasonable” include “fair, proper, or moderate” and “not excessive.”

See

76 FR at 43423. The Board also noted that the Board did not believe that it was consistent with the statutory purpose to permit networks to set interchange fees in order to accommodate 100 percent of the average per-transaction costs of the highest-cost issuers.

See

76 FR at 43433.

A useful measure of the difference between covered issuer transactions above the target percentile (for which the Board believes full cost recovery would be unreasonable) and covered issuer transactions below the target percentile (for which the Board believes full cost recovery would be reasonable) is the efficiency gap with respect to transaction processing between covered issuers whose transactions are above and below the target percentile. This efficiency gap may be represented by the ratio of the transaction-weighted average of per-transaction base component costs for covered issuers whose transactions are above the target percentile to that for covered issuers whose transactions are below the target percentile. The Board computed this ratio for a range of potential cost-recovery targets using each set of data collected from covered issuers since 2009.

46

For the proposed cost-recovery target of 98.5 percent of covered issuer transactions, the average value of this ratio across these data collections is approximately 5.2, meaning that covered issuers whose transactions are above the 98.5 percentile are, on average, more than five times less efficient than covered issuers whose transactions are below the 98.5

percentile. Accordingly, the Board believes that targeting full cost recovery over time for 98.5 percent of covered issuers transactions is reasonable.

46

See

section VII,

infra,

for the average value of this ratio across these data collections for a range of potential cost-recovery targets.

Although the proposed new methodology for determining the base component would ultimately rely on a simple formula (

i.e.,

the transaction-weighted average of per-transaction base component costs across covered issuers multiplied by 3.7), the Board appreciates that the underlying statistical analysis is complex. The Board considered other methodologies for determining the base component. For example, the Board considered setting the base component equal to the transaction-weighted average of per-transaction base component costs across covered issuers (

i.e.,

effectively with a fixed multiplier of 1.0), but determined that this methodology would result in an unreasonably low percentage of covered issuers fully recovering their costs.

47

The Board also considered determining the base component by reference to a target percentile in (i) the distribution of per-transaction base component costs, arranged from lowest- to highest-cost covered issuer, or (ii) the distribution of per-transaction base component costs across covered issuer transactions. In both cases, however, the Board determined that these methodologies could result in a base component that does not reflect changes over time in the transaction-weighted average of per-transaction base component costs across covered issuers due to the sensitivity of these alternative methodologies to low-volume, high-cost covered issuers. Finally, the Board considered adopting a tiered approach that would establish different base components for high-volume, low-cost covered issuers and low-volume, high-cost covered issuers. However, the Board determined that such an approach would create numerous practical challenges for both the Board and debit card industry participants and could disincentivize covered issuers in the tier with the higher base component from growing their debit card programs.

48

47

Specifically, setting the base component equal to the transaction-weighted average of per-transaction base component costs across covered issuers would have resulted in only around 15 percent of covered issuers, on average across the biennial data collections, fully recovering their base component costs. Such a methodology would, however, permit covered issuers as a whole to recover their aggregate base component costs.

48

For example, a tiered base component approach would require the Board to demarcate different tiers of issuers, and the Board's demarcations would likely need to be adjusted over time. In addition, networks would need to track covered issuers by tier to ensure that the interchange fees received by each covered issuer do not exceed the interchange fee standards.

Whereas the Board proposes a new methodology to determine the base component, the Board does not propose to revise the original methodology that the Board used to determine the

ad valorem

component (

i.e.,

the median ratio of issuer fraud losses to transaction value among covered issuers, multiplied by the value of the transaction). Since the Board adopted the interchange fee standards in 2011, the Board has observed an overall increase in fraud losses to all parties related to covered issuer transactions, but the share of such fraud losses absorbed by covered issuers (

i.e.,

issuer fraud losses) has declined during that time. Accordingly, as noted above, the median ratio of issuer fraud losses to transaction value among covered issuers has declined from 2011 to 2021, despite the overall increase in fraud losses to all parties.

49

The Board originally determined the

ad valorem

component using only those fraud losses absorbed by covered issuers, and analysis of the data collected by the Board since the original Regulation II rulemaking shows that, despite these changes in the fraud environment, the median ratio of issuer fraud losses to transaction value among covered issuers remains a representative metric of the cost of fraud incurred by covered issuers. Therefore, for the reasons explained in the preamble accompanying the 2011 final rule, the Board believes that the original methodology continues to be appropriate for determining the

ad valorem

component.

50

49

For additional information regarding fraud losses with respect to covered issuer transactions, see section VIII.C,

infra.

50

See

76 FR at 43431 and 43434. The Board recognizes that some aspects of the fraud environment have changed with, for example, the introduction of increased security for in-person card payments through the issuance of chip-based EMV cards and the growth of ecommerce and remote fraud. As discussed in section VIII.C,

infra,

covered issuers now absorb a smaller percentage of fraud losses from covered issuer transactions than they did in 2009, with both cardholders and merchants absorbing larger proportions of such losses over time. Notwithstanding these changes, the Board believes that its conclusions with respect to the

ad valorem

component remain sound. Furthermore, because the methodology for determining the

ad valorem

component is based on actual fraud losses absorbed by covered issuers, any future decrease or increase in the median ratio of issuer fraud losses to transaction value among covered issuers would, pursuant to the Board's proposed methodology, result in a corresponding future reduction or increase to the

ad valorem

component.

C. Description of Proposal

The Board proposes to determine, for every two-year period, the base component and the

ad valorem

component using the latest data reported to the Board by covered issuers on the Debit Card Issuer Survey. Further, the Board proposes a new methodology for determining the base component. Initially, under the proposed approach, the base component would be 14.4 cents and the

ad valorem

component would be 4.0 basis points (multiplied by the value of the transaction) for debit card transactions performed from the effective date of the final rule to June 30, 2025. The Board does not propose to modify the allowable costs considered for purposes of determining the base component and the

ad valorem

component, or the original methodology used to determine the

ad valorem

component.

Proposed § 235.3(b)(1) would provide that the current base component of 21.0 cents and the current

ad valorem

component of 5.0 basis points (multiplied by the value of the transaction) would continue to apply for debit card transactions performed from October 1, 2011 (the original effective date of § 235.3) until the calendar day prior to the effective date of the final rule. Proposed § 235.3(b)(2) would establish the base component and the

ad valorem

component that would apply for debit card transactions performed from the effective date of the final rule to June 30, 2025. Specifically, for these transactions, the base component would be 14.4 cents, and the

ad valorem

component would be 4.0 basis points (multiplied by the value of the transaction). As described in section III.B,

supra,

the proposed base component of 14.4 cents is the transaction-weighted average of per-transaction allowable costs (excluding fraud losses) across covered issuers based on the data reported on the 2021 Debit Card Issuer Survey (3.9 cents) multiplied by the fixed multiplier of 3.7 and rounded to the nearest tenth of one cent. The proposed

ad valorem

component of 4.0 basis points (multiplied by the value of the transaction) is the median ratio of issuer fraud losses to transaction value among covered issuers based on the data reported on the 2021 Debit Card Issuer Survey, rounded to the nearest quarter of one basis point.

51

51

The Board proposes to round the

ad valorem

component to the nearest quarter of one basis point to achieve a similar degree of accuracy as for the base component, which the Board proposes to round to the nearest tenth of one cent. Specifically, for a $50 debit card transaction subject to the interchange fee standards, a change in the

ad valorem

component of one quarter of one basis point would result in a change of around one tenth of one cent to the maximum interchange fee permitted under the interchange fee standards.

The Board proposes a set of conforming revisions to comments 235.3(b)-2 and 235.3(b)-3 of the Official Commentary to make clear that the base component and the

ad valorem

component for a particular transaction depend on the date on which the transaction is performed. Proposed new comment 235.3(b)-4 would provide that, for this purpose, a debit card transaction is considered to be performed on the date on which the transaction is settled on an interbank basis.

Proposed new paragraph (c) to § 235.3 would set forth the basis for determining the amounts in proposed § 235.3(b). Specifically, proposed § 235.3(c) would provide that, for every two-year period, beginning with the period from July 1, 2025, to June 30, 2027, the Board will determine the base component and the

ad valorem

component using the approach described in a new proposed appendix B to Regulation II. Paragraph (a) to proposed appendix B would similarly state that the Board will determine the base component and the

ad valorem

component for each “applicable period” (

i.e.,

every two-year period beginning with the period from July 1, 2025, to June 30, 2027) using the approach described in proposed appendix B.

Paragraph (b) of proposed appendix B would set forth the data that the Board would use to determine the base component and

ad valorem

component for each applicable period—namely, the latest data reported to the Board by covered issuers on the Debit Card Issuer Survey. Specifically, paragraph (b) would provide that the Board will determine the base component and the

ad valorem

component for each applicable period using the data reported to the Board by covered issuers pursuant to § 235.8 concerning transactions performed during the calendar year that is two years prior to the year in which that applicable period begins. For example, in the case of the applicable period beginning July 1, 2025, the Board would use the data reported to the Board by covered issuers on the Debit Card Issuer Survey concerning debit card transactions performed in calendar year 2023, which the Board will collect in 2024.

Paragraph (c)(1) of proposed appendix B would establish the formula that the Board would use to determine the base component for each applicable period. Specifically, for each applicable period, the base component would be the product of the transaction-weighted average of per-transaction allowable costs (excluding fraud losses) across covered issuers and 3.7, rounded to the nearest tenth of one cent.

52

Paragraph (c)(2) would define “allowable costs (excluding fraud losses)”—which is synonymous with the term “base component costs” used elsewhere in this preamble—as the sum of the costs of authorization, clearance, and settlement, as reported on the Debit Card Issuer Survey,

53

and transaction-monitoring costs tied to authorization, as reported on the Debit Card Issuer Survey.

54

Paragraph (c)(3) would set forth how the Board calculates the transaction-weighted average of per-transaction allowable costs (excluding fraud losses) across issuers. Specifically, using the latest data reported to the Board by covered issuers, the Board would (i) sum allowable costs (excluding fraud losses) across covered issuers that reported allowable costs (excluding fraud losses); (ii) divide this sum by the sum of the total number of debit card transactions across covered issuers that reported allowable costs (excluding fraud losses); and (iii) round this result to the nearest tenth of one cent.

55

52

Section III.B,

supra,

describes the Board's rationale for proposing 3.7 as the fixed multiplier for determining the base component.

53

These costs are reported on line 3a of section II of the Debit Card Issuer Survey as “costs of authorization, clearance, and settlement.”

See

FR 3064a.

54

These costs are reported on line 5a.1 of section II of the Debit Card Issuer Survey as “transactions monitoring costs tied to authorization.”

See id.

55

The total number of debit card transactions attributable to a covered issuer is reported on line 1a of section II of the Debit Card Issuer Survey as the volume of “settled purchase transactions (excluding pre-authorizations, denials, adjustments, returns, and cash back amounts).”

See id.

Paragraph (d)(1) of proposed appendix B would establish the metric that the Board would use to determine the

ad valorem

component for each applicable period. Specifically, for each applicable period, the

ad valorem

component for a particular debit card transaction would be the median ratio of issuer fraud losses to transaction value among covered issuers, rounded to the nearest quarter of one basis point, multiplied by the value of the debit card transaction. Paragraph (d)(2) would define “ratio of issuer fraud losses to transaction value” as the value of fraud losses incurred by the covered issuer, as reported on the Debit Card Issuer Survey,

56

divided by the total value of debit card transactions, as reported on the Debit Card Issuer Survey.

57

Paragraph (d)(3) would set forth how the Board calculates the median ratio of issuer fraud losses to transaction value among covered issuers. Specifically, using the latest data reported to the Board by covered issuers, the Board would (i) determine the ratio of issuer fraud losses to transaction value for each covered issuer that reported issuer fraud losses, (ii) sort these ratios in ascending order, and (iii) select the ratio in the middle (if the number of ratios is odd) or calculate the simple average of the two ratios in the middle (if the number of ratios is even).

56

These costs are reported on line 8b of section II of the Debit Card Issuer Survey as “losses incurred by issuer” (

i.e.,

gross value of fraudulent transactions, less fraud-related chargebacks to acquirers net of representments, and less losses absorbed by cardholders).

See id.

57

The total value of debit card transactions attributable to a covered issuer is reported on line 1a of section II of the Debit Card Issuer Survey as the value of “settled purchase transactions (excluding pre-authorizations, denials, adjustments, returns, and cash back amounts).”

See id.

Paragraph (f) of proposed appendix B would establish the timing of the publication of the base component and

ad valorem

component for an applicable period. Specifically, the Board would publish these amounts in the

Federal Register

no later than March 31 of the calendar year in which the applicable period begins. Because the Board would determine these amounts by applying the approach described in proposed appendix B and using the latest data reported to the Board by covered issuers, the Board would not intend to seek public comment on future updates to these amounts.

58

58

See, e.g.,

5 U.S.C. 553(b)(3)(B) (exempting agencies from notice and comment rulemaking when the agency for good cause finds that such procedures are impracticable, unnecessary, or contrary to the public interest). The Board believes that future determinations of the base component and the

ad valorem

component should qualify for the good cause exemption from notice and comment rulemaking because such determinations would involve the ministerial application of the approach described in proposed appendix B, and the Board would not be exercising any discretion in connection with such determinations. The Board would seek public comment on any future substantive changes to the proposed approach.

IV. Proposed Revisions to Fraud Prevention Adjustment (§ 235.4)

A. Background

As described above, under EFTA section 920(a)(5)(A), the Board may allow for an adjustment to the interchange fee received or charged by an issuer under the interchange fee standards if such adjustment is reasonably necessary to make allowance for costs incurred by the issuer in preventing fraud in relation to debit card transactions involving the issuer, provided that the issuer complies with fraud-related standards established by the Board. The Board's fraud-related standards must (i) be designed to ensure that any fraud-prevention adjustment is limited to the amount that is reasonably necessary to make allowance for costs

incurred by the issuer in preventing fraud in relation to debit card transactions involving the issuer and takes into account any fraud-related reimbursements (including amounts from chargebacks) received from consumers, merchants, or payment card networks in relation to debit card transactions involving the issuer; and (ii) require issuers to take effective steps to reduce the occurrence of, and costs from, fraud in relation to debit card transactions, including through the development and implementation of cost-effective fraud prevention technology.

59

EFTA section 920(a)(5)(B) requires the Board to prescribe regulations to establish standards for making any such fraud-prevention adjustment.

60

59

EFTA section 920(a)(5)(A)(ii). The Board does not propose revisions to the current fraud-prevention standards in § 235.4(b). For the reasons explained in the preamble accompanying the 2012 final rule, the Board adopted a non-prescriptive approach to these standards.

See

77 FR 46258, 46268-75 (Aug. 3, 2012). The fraud-prevention standards require issuers to develop and implement policies and procedures reasonably designed to take effective steps to reduce the occurrence of, and costs to all parties from, fraudulent debit card transactions, including through the development and implementation of cost-effective fraud-prevention technology.

See

§ 235.4(b)(1). Specifically, an issuer's policies and procedures must address: (i) methods to identify and prevent fraudulent debit card transactions; (ii) monitoring of the volume and value of its fraudulent debit card transactions; (iii) appropriate responses to suspicious debit card transactions in a manner designed to limit the costs to all parties from and prevent the occurrence of future fraudulent debit card transactions; (iv) methods to secure debit card and cardholder data; and (v) such other factors as the issuer considers appropriate.

See

§ 235.4(b)(2). An issuer must review, at least annually, its fraud-prevention policies and procedures, and their implementation, and update them as necessary in light of: (i) their effectiveness in reducing the occurrence of, and costs to all parties from, fraudulent debit card transactions involving the issuer; (ii) their cost-effectiveness; and (iii) changes in the types of fraud, methods used to commit fraud, and available methods for detecting and preventing fraudulent debit card transactions that the issuer identifies from (A) its own experience or information, (B) information provided to the issuer by its payment card networks, law enforcement agencies, and fraud-monitoring groups in which the issuer participates, and (C) applicable supervisory guidance.

See

§ 235.4(b)(3). In order to charge or receive the fraud-prevention adjustment, an issuer must annually notify its payment card networks that it complies with the Board's fraud-prevention standards, and must notify its payment card networks if it is no longer eligible to receive or charge the fraud-prevention adjustment.

See

§ 235.4(c) and (d).

60

In issuing regulations to implement any fraud-prevention adjustment, the Board must consider certain factors set forth in EFTA section 920(a)(5)(B)(ii), which are discussed in section VIII.C,

infra.

The Board adopted a fraud-prevention adjustment and fraud-prevention standards in § 235.4 of Regulation II.

61

In adopting the fraud-prevention adjustment, the Board (i) defined the fraud-prevention costs that issuers incur and (ii) structured the fraud-prevention adjustment to allow issuers to recover a portion of these costs. A brief overview of how the Board developed the fraud-prevention adjustment in current § 235.4 follows.

61

Section 235.4 was initially adopted via an interim final rule in July 2011.

See

76 FR 43477 (July 20, 2011). The Board subsequently issued a final rule that made various amendments to the interim final rule. S

ee

77 FR 46258 (Aug. 3, 2012).

1. Fraud-Prevention Costs

EFTA section 920 does not specify types of fraud-prevention costs incurred by issuers that the Board may or may not consider in determining the fraud-prevention adjustment. When the Board adopted current § 235.4, the Board explained that fraud prevention involves a broad range of activities in which an issuer may engage before, during, or after a debit card transaction.

62

Accordingly, and for reasons explained in the preamble accompanying the 2012 final rule, the Board considered costs incurred by debit card issuers associated with a variety of activities that contribute to preventing fraud, including research and development of new fraud-prevention technologies, card reissuance due to fraudulent activity, data security, card activation, and merchant blocking. However, the Board did not consider transaction-monitoring costs to be a fraud-prevention cost for purposes of determining the fraud-prevention adjustment because the Board included transaction-monitoring costs in allowable costs for purposes of the interchange fee standards.

63

The Board also did not consider costs incurred to prevent fraud to a cardholder's transaction account through means other than debit card transactions, or costs incurred to prevent fraud in connection with other payment methods such as credit cards. Additionally, fraud losses, lost revenue attributable to cardholders waiting for replacement cards, fraud-loss insurance, and recovering losses were not included in fraud-prevention costs.

64

62

77 FR 46258, 46264 (Aug. 3, 2012).

63

See id.; see also

76 FR 43393, 43431 (July 20, 2011) (noting that the types of fraud-prevention activities considered in connection with the fraud-prevention adjustment are those activities that prevent fraud with respect to debit card transactions at times other than when the issuer is effecting the transaction); 80 FR 48684, 48685 (Aug. 14, 2015) (same).

64

77 FR at 46264.

2. Fraud-Prevention Adjustment

When the Board adopted the fraud-prevention adjustment as an interim final rule in 2011, the Board noted that the statute does not specify what amount, or range of amounts, is reasonably necessary to make allowance for an issuer's fraud-prevention costs. The Board concluded that an amount that makes allowance for an issuer's fraud-prevention costs is one that gives consideration to those costs and allows a reasonable recovery of those costs based on the considerations set forth in EFTA section 920(a)(5)(B)(ii).

65

65

76 FR at 43482. The Board rejected an interpretation that would require a direct connection between the fraud-prevention adjustment and actual issuer costs. The Board also did not interpret the statute to require the fraud-prevention adjustment to permit each (or any) issuer to fully recover its fraud-prevention costs.

See id.

For the reasons explained in the preamble accompanying the 2012 final rule, the Board adopted a fraud-prevention adjustment of 1 cent per transaction.

66

This amount corresponded to the difference, rounded to the nearest whole cent, between the median per-transaction fraud-prevention costs aggregated with transaction-monitoring costs among covered issuers (1.8 cents) and the median per-transaction transaction-monitoring costs among covered issuers (0.7 cents), based on the data collected on the Board's voluntary survey.

67

66

77 FR at 46265-66.

67

77 FR at 46263.

The Board described the foregoing methodology for determining the fraud-prevention adjustment in the preamble accompanying the 2012 final rule. The Board did not, however, codify this methodology in § 235.4. Rather, § 235.4(a) simply provides that, subject to compliance with the Board's fraud-prevention standards, an issuer may receive or charge an amount of no more than 1.0 cent per transaction in addition to any interchange fee it receives or charges in accordance with § 235.3.

B. Rationale for Proposal

When the Board adopted the fraud-prevention adjustment in current § 235.4, the Board stated that it would take into account data from future Debit Card Issuer Surveys when considering any future revisions to the fraud-prevention adjustment.

68

Consistent with EFTA section 920(a)(3)(B), the Board has surveyed covered issuers on a mandatory basis every other year since the reporting requirements in § 235.8 of Regulation II were adopted. Through these biennial surveys, the Board has collected data from covered issuers concerning the costs incurred by covered issuers in connection with debit card transactions performed in calendar years 2011, 2013, 2015, 2017, 2019, and

2021. These data show that fraud-prevention costs have risen since 2009. Specifically, the median per-transaction fraud-prevention costs among covered issuers was 1.3 cents in 2021.

69

68

77 FR at 46266.

69

The Board computes the median per-transaction fraud-prevention among covered issuers by (i) for each covered issuer that reported fraud-prevention costs, dividing the covered issuer's fraud-prevention costs by the total number of debit card transactions reported by the covered issuer; (ii) sorting these values in ascending order; and (iii) selecting the value in the middle (if the number of values is odd) or calculating the simple average of the two values in the middle (if the number of values is even).

Given this development, the Board believes it is necessary to revise the fraud-prevention adjustment to reflect the increase since 2009 in fraud-prevention costs. In addition—and for the reasons explained in section III.B,

supra,

in connection with the interchange fee standards—the Board believes that, as much as practicable, the fraud-prevention adjustment should be updated regularly and predictably to reflect changes in the fraud-prevention costs incurred by covered issuers as those changes occur. Accordingly, the Board proposes to determine the fraud-prevention adjustment in § 235.4 every other year based on the latest data reported to the Board by covered issuers. The Board believes that, under this approach, the fraud-prevention adjustment in § 235.4 will continue over time to reflect an amount that is reasonably necessary to make allowance for costs incurred by an issuer in preventing fraud in relation to debit card transactions involving that issuer.

The Board also proposes to modify the original methodology used to determine the fraud-prevention adjustment. When the Board adopted current § 235.4, the Board's objective was to determine the fraud-prevention adjustment as the median per-transaction fraud-prevention costs among covered issuers. However, due to limitations in the data reported to the Board by covered issuers on the Board's voluntary survey, the Board did not directly calculate this metric, but rather approximated it by calculating the difference between (i) the median per-transaction fraud-prevention costs aggregated with transaction-monitoring costs among covered issuers, and (ii) the median per-transaction transaction-monitoring costs among covered issuers, rounded to the nearest cent.

70

However, these limitations no longer persist in the data collected since the reporting requirements in § 235.8 of Regulation II were adopted.

71

As a result, the Board is now able to directly calculate this metric. Therefore, as described below, the Board proposes to determine the fraud-prevention adjustment as the median per-transaction fraud-prevention costs among covered issuers, rounded to the nearest tenth of one cent.

70

Specifically, the Board's voluntary survey asked covered issuers to report (i) their fraud-prevention costs aggregated with transaction-monitoring costs, and also to break out, if possible, (ii) their transaction-monitoring costs. Some covered issuers reported the first figure but not the second. Instead of directly calculating the median per-transaction fraud-prevention costs among covered issuers—which would have required the Board to rely on a smaller data set comprised only of those covered issuers that reported both figures—the Board approximated this metric by calculating the difference between (i) the median per-transaction fraud-prevention costs aggregated with transaction-monitoring costs among covered issuers that reported their fraud prevention costs aggregated with transaction-monitoring costs, and (ii) the median per-transaction transaction-monitoring costs among covered issuers that broke out their transaction-monitoring costs.

71

Specifically, beginning with the first mandatory Debit Card Issuer Survey, a more representative number of covered issuers have reported their fraud-prevention costs disaggregated from their transaction-monitoring costs.

The Board believes that the original methodology, with the proposed modification, continues to be an appropriate methodology for determining the fraud-prevention adjustment, both for the reasons explained in the preamble accompanying the 2012 final rule, and in light of the factors set forth in EFTA section 920(a)(5)(B)(ii), which are discussed in section VIII.C,

infra.

C. Description of Proposal

The Board proposes to determine, for every two-year period, the fraud-prevention adjustment based on the latest data reported to the Board by covered issuers on the Debit Card Issuer Survey. Further, the Board proposes to modify the original methodology used to determine the fraud-prevention adjustment. The Board does not propose to modify the fraud-prevention costs considered for purposes of determining the fraud-prevention adjustment, or the fraud-prevention standards that covered issuers must meet to receive the fraud-prevention adjustment.

Proposed § 235.4(a)(1) would provide that the fraud-prevention adjustment of 1.0 cents would continue to apply for debit card transactions performed from October 1, 2011 (the original effective date of § 235.4) until the calendar day prior to the effective date of the final rule. Proposed § 235.4(a)(2) would establish the fraud-prevention adjustment (1.3 cents) that would apply for debit card transactions performed from the effective date of the final rule to June 30, 2025. Proposed new comment 235.4(a)-1 would provide that, for purposes of § 235.4(a), a debit card transaction is considered to be performed on the date on which the transaction is settled on an interbank basis.

Proposed new paragraph (b) to § 235.4 would set forth the basis for determining the fraud-prevention adjustment in proposed § 235.4(a). Specifically, proposed § 235.4(b) would provide that, for every two-year period, beginning with the period from July 1, 2025, to June 30, 2027, the Board will determine the fraud-prevention adjustment using the approach described in proposed appendix B to Regulation II. Paragraph (a) to proposed appendix B similarly would state that the Board will determine the fraud-prevention adjustment for each “applicable period” (

i.e.,

every two-year period beginning with the period from July 1, 2025, to June 30, 2027) using the approach described in proposed appendix B.

Paragraph (b) of proposed appendix B would set forth the data that the Board would use to determine the fraud-prevention adjustment for each applicable period—namely, the latest data reported to the Board by covered issuers on the Debit Card Issuer Survey. Specifically, paragraph (b) would provide that the Board will determine the fraud-prevention adjustment for each applicable period using the data reported to the Board by covered issuers pursuant to § 235.8 concerning transactions performed during the calendar year that is two years prior to the year in which that applicable period begins. For example, in the case of the applicable period beginning July 1, 2025, the Board would use the data reported to the Board by covered issuers on the Debit Card Issuer Survey concerning debit card transactions performed in calendar year 2023, which the Board will collect in 2024.

Paragraph (e)(1) of proposed appendix B would establish the metric that the Board would use to determine the fraud-prevention adjustment for each applicable period. Specifically, for each applicable period, the fraud-prevention adjustment would be the median per-transaction fraud-prevention costs among covered issuers, rounded to the nearest tenth of one cent. Paragraph (e)(2) would define “per-transaction fraud-prevention costs” as fraud-prevention costs, as reported on the Debit Card Issuer Survey,

72

divided by

the total number of debit card transactions, as reported on the Debit Card Issuer Survey.

73

Paragraph (e)(3) would set forth how the Board calculates the median per-transaction fraud-prevention costs among covered issuers. Specifically, using the latest data reported to the Board by covered issuers, the Board would (i) determine the per-transaction fraud-prevention costs for each covered issuer that reported fraud-prevention costs, (ii) sort these values in ascending order, and (iii) select the value in the middle (if the number of values is odd) or calculate the simple average of the two values in the middle (if the number of values is even).

72

Fraud-prevention costs are (i) “total fraud-prevention and data-security costs,” as reported on line 5a of section II of the Debit Card Issuer Survey, minus (ii) “transactions monitoring costs tied to authorization,” as reported on line 5a.1 of section II of the Debit Card Issuer Survey.

See

FR 3064a.

73

The total number of debit card transactions attributable to a covered issuer is reported on line 1a of section II of the Debit Card Issuer Survey as the volume of “settled purchase transactions (excluding pre-authorizations, denials, adjustments, returns, and cash back amounts).”

See id.

Paragraph (f) of proposed appendix B would set forth the timing of the publication of the fraud-prevention adjustment for an applicable period. Specifically, the Board would publish the fraud-prevention adjustment in the

Federal Register

no later than March 31 of the calendar year in which the applicable period begins. Because the Board would determine the fraud-prevention adjustment by applying the methodology described in proposed appendix B and using the latest data reported to the Board by covered issuers, the Board would not intend to seek public comment on future updates to the fraud-prevention adjustment.

74

74

As with future determinations of the base component and the

ad valorem

component, the Board believes that future determinations of the fraud-prevention adjustment should qualify for the good cause exemption from notice and comment rulemaking.

See supra

note 58.

V. Other Proposed Revisions

In addition to the proposed revisions to the interchange fee standards in § 235.3 and the fraud-prevention adjustment in § 235.4, the Board proposes a set of technical revisions to Regulation II. In general, these proposed revisions are intended to make Regulation II clearer. Additionally, some of the proposed revisions are intended to ensure the text of the regulation directly incorporates the Board's current construction of the rule.

First, to improve the readability of Regulation II, the Board proposes to add “covered issuer” as a defined term in § 235.2. Under the proposal, “covered issuer” would mean, for a particular calendar year, an issuer that, together with its affiliates, has assets of $10 billion or more as of the end of the preceding calendar year.

75

Further, the Board proposes certain conforming revisions to the regulation to reflect the addition of “covered issuer” as a defined term. For example, the Board proposes to move current comment 235.5(a)-1, which describes which assets do and do not count toward the $10 billion threshold, to the commentary under § 235.2. In addition, the Board proposes to incorporate the defined term “covered issuer” where relevant in other sections of Regulation II, particularly in § 235.5(a) (the small issuer exemption) and § 235.8(a) (reporting requirements) and the commentary thereto. The Board does not intend the addition and incorporation of the defined term “covered issuer” to be a substantive change.

75

The proposed definition is derived from current § 235.5(a)(1)(ii).

Second, the Board identified three sentences in the commentary to current § 235.2(k) (definition of “issuer”) that relate to an issuer's eligibility for the small issuer exemption in § 235.5(a). The Board proposes to move the substance of these sentences into the commentary to § 235.5(a). The Board does not intend this proposed revision to modify the definition of “issuer” or alter any issuer's eligibility for the small issuer exemption.

Third, the Board proposes minor revisions to add specificity to § 235.8 (reporting requirements and record retention) and the commentary thereto. Specifically, the Board proposes to specify in § 235.8(a) that each covered issuer must file a report with the Board on a biennial basis, and that each payment card network must file a report with the Board on an annual basis, consistent with the Board's survey practices since 2011. Further, the Board proposes to add new comment 235.8(a)-1 to specify that the reports referred to in proposed § 235.8(a) are the Board's biennial Debit Card Issuer Survey and annual Payment Card Network Survey, and that each survey collects information concerning debit card transactions performed during the previous calendar year. In addition, the Board proposes to add new comment 235.8(a)-2 to specify that newly covered issuers are exempt from the Debit Card Issuer Survey, consistent with the current instructions to that survey.

76

The Board believes that these proposed revisions are helpful in light of the significance of the data collected on the Debit Card Issuer Survey to the proposed approach for determining the base component, the

ad valorem

component, and the fraud-prevention adjustment.

76

The General Instructions to the Debit Card Issuer Survey currently provide that “[i]f an issuer that is covered by the interchange fee standards in Regulation II at the time of this data collection was not also covered in [the previous calendar year], it does not need to file a report . . . .”

See

FR 3064a.

Fourth, the Board proposes to remove § 235.7(c), the commentary to § 235.7(c), and § 235.10 of Regulation II. These sections of the regulation specify the original effective date of Regulation II (October 1, 2011) and give debit card issuers and networks additional time to comply with the requirements in § 235.7(a) for certain types of debit cards, such as general-use prepaid cards and debit cards that use point-of-sale transaction qualification or substantiation systems for verifying the eligibility of purchased goods or services. Both the original effective date of Regulation II and these extended compliance dates have long since passed. As such, the Board believes that these provisions of Regulation II are no longer necessary.

77

In addition, deleting these provisions would avoid the potential for confusion regarding the effective date of any future revisions to the requirements in § 235.7(a).

78

77

For the same reason, the Board proposes to remove § 235.5(a)(4), which temporarily modified the application of the small issuer exemption due the COVID-19 pandemic.

See

85 FR 77345 (Dec. 2, 2020). Because the last debit card transactions to which § 235.5(a)(4) applied were performed on December 31, 2021, the Board proposes to remove § 235.5(a)(4) with an effective date of January 1, 2027, which is after the five-year record retention requirement prescribed in § 235.8(c)(1) will have elapsed with respect to these transactions. The effective date of the other proposed revisions described in this preamble is discussed in section VI,

infra.

78

The Board does not anticipate any future revisions to § 235.7(a) at this time. However, questions regarding the effective date arose in connection with the Board's recent revisions to § 235.7(a) and the commentary thereto.

See

87 FR 61217 (Oct. 11, 2022).

Fifth, the Board proposes minor revisions to § 235.4 (in addition to those described in section IV.C,

supra

) and the commentary to § 235.3(b) (in addition to those described in section III.C,

supra

) to clarify the relationship between the interchange fee standards in § 235.3 and the fraud-prevention adjustment in § 235.4. Specifically, the Board proposes to modify the first sentence of § 235.4(a) to clarify that the fraud-prevention adjustment is in addition to any interchange fee an issuer receives or charges in accordance with § 235.3. Further, the Board proposes to add a sentence in both comments 235.3(b)-1 and 235.3(b)-3 stating that, in addition to the base component and

ad valorem

component, an issuer may be permitted to receive a fraud-prevention adjustment under § 235.4.

Although the Board does not believe that debit card industry participants currently misunderstand the relationship between the interchange fee standards in § 235.3 and the fraud-prevention adjustment in § 235.4, the proposed revisions would eliminate any doubt that the maximum permissible interchange fee amount that a covered issuer may receive for a transaction subject to the interchange fee standards is the sum of the base component, the

ad valorem

component, and, if the covered issuer is eligible, the fraud-prevention adjustment.

Finally, the Board proposes to remove the first clause of § 235.5(a)(1), which cross-references § 235.5(a)(3) (transition period for newly covered issuers) and characterizes the latter paragraph as an exception to the small issuer exemption in § 235.5(a)(1). The Board believes that characterizing § 235.5(a)(3) as an exception to § 235.5(a)(1) is potentially confusing, as § 235.5(a)(3) adds to, rather than subtracts from, the relief provided in § 235.5(a)(1) by providing additional, temporary relief to newly covered issuers that would not otherwise qualify for the relief provided in § 235.5(a)(1). The proposed revision would clarify the relationship between these two paragraphs in § 235.5(a) but is not intended to alter any issuer's eligibility for the small issuer exemption.

VI. Effective Date of Proposed Revisions

With one exception,

79

the Board proposes that the revisions would, if adopted, take effect on the first day of the next calendar quarter that begins at least 60 days after the final rule is published in the

Federal Register

.

80

Such an implementation period would be similar to the implementation period of the current interchange fee standards, which the Board published on July 20, 2011, and became effective on October 1, 2011.

81

79

Unlike the other proposed revisions described in this preamble, the proposed deletion of § 235.5(a)(4) would, if adopted, take effect on January 1, 2027.

See supra

note 77.

80

Section 302 of the Riegle Community Development and Regulatory Improvement Act, Public Law 103-325, requires that amendments to regulations prescribed by a Federal banking agency that impose additional requirements on insured depository institutions must take effect on the first day of a calendar quarter that begins on or after the date of publication in the

Federal Register

.

See

12 U.S.C. 4802.

81

The Board notes that, compared with the original rulemaking in which the Board adopted current § 235.3, the proposed revisions would represent a significantly smaller reduction in the amount of interchange fees that covered issuers may receive for transactions subject to the interchange fee standards. In addition, at the time of the original rulemaking, there was significant uncertainty as to whether payment card networks would implement different interchange fee schedules for transactions subject to and exempt from the interchange fee cap. Since that time, all networks have established different interchange fee schedules for transactions subject to and exempt from the interchange fee cap.

Once the proposed revisions are effective, and as described in sections III.C and IV.C,

supra,

the proposed base component (14.4 cents),

ad valorem

component (4.0 basis points multiplied by the value of the transaction), and fraud-prevention adjustment (1.3 cents) would be in effect through June 30, 2025. On July 1, 2025, a new base component,

ad valorem

component, and fraud-prevention adjustment would take effect. The Board would determine these amounts using the approach described in proposed appendix B based on the data reported to the Board by covered issuers on the Debit Card Issuer Survey in 2024 (concerning debit card transactions performed in calendar year 2023), and would publish these values in the

Federal Register

no later than March 31, 2025.

VII. Request for Comment

The Board invites comment on all aspects of the proposed revisions.

82

In addition, the Board invites feedback on the following specific questions related to the proposal:

82

As noted in section III.A,

supra,

the Board has reviewed its construction of the statute and prior analysis regarding the allowable costs that the Board considered in establishing the interchange fee standards, and believes that this prior analysis remains sound. As such, the Board is not inviting comments on the allowable costs considered for purposes of the interchange fee standards.

83

The transaction-weighted average of per-transaction base component costs across covered issuers, rounded to the nearest tenth of one cent, for transactions performed in 2021 was 3.9 cents. For purposes of comparison, the same average for transactions performed in 2009 and 2011 was 7.7 cents and 5.1 cents, respectively. The base component values listed are the product of 3.9 cents and the relevant fixed multiplier.

84

As described in section III.B,

supra,

this efficiency gap is represented by the ratio of the transaction-weighted average of per-transaction base component costs for covered issuers whose transactions are above the target percentile to that for covered issuers whose transactions are below the target percentile.

1. As stated in paragraph (a) of proposed appendix B to Regulation II, the Board would determine the base component,

ad valorem

component, and fraud-prevention adjustment for every two-year period, beginning with the period from July 1, 2025, to June 30, 2027. Is the proposed two-year cadence appropriate, or should the Board determine these amounts more or less frequently?

2. As described in paragraph (c)(1) of proposed appendix B to Regulation II, the Board would determine the base component as a fixed multiple of the transaction-weighted average of per-transaction base component costs (

i.e.,

allowable costs (excluding fraud losses)) across covered issuers. As described in section III.B,

supra,

the fixed multiplier corresponds to the percentage of covered issuer transactions for which the Board believes covered issuers should fully recover their base component costs over time. Should the Board select an alternative cost-recovery target from among the possibilities below, or another cost-recovery target not included below? If so, why?

3.

Cost-recovery

target

(percentage of covered issuer

transactions)

(%)

Fixed multiplier

Base component

(based on 2021 data)

83

(cents)

Decline in base component

relative to current

(based on 2021 data)

(%)

Efficiency gap with respect to transaction processing

between covered issuers whose transactions are above and below the

cost-recovery target

(based on 2021 data)

84

Percentage of covered issuers

that would have fully

recovered their base

component costs in 2021 had the relevant base component been in effect in 2021

(based on 2021 data)

(%)

Current

21.0

77

99.5

4.5

17.6

16

7.7

76

99.0

4.0

15.6

26

5.8

71

* 98.5

3.7

14.4

31

5.2

66

98.0

3.5

13.7

35

4.7

63

95.0

2.7

10.5

50

3.8

52

* Proposal.

4. As described in paragraph (d)(1) of proposed appendix B to Regulation II, the Board would determine the

ad valorem

component, for a particular debit card transaction, as the median ratio of issuer fraud losses to transaction value among covered issuers, multiplied by the value of the transaction. Should the Board adopt an alternative methodology for determining the

ad valorem

component? If so, why?

5. As described in paragraph (e)(1) of proposed appendix B to Regulation II, the Board would determine the fraud-prevention adjustment as the median per-transaction fraud-prevention costs among covered issuers. Should the Board adopt an alternative methodology for determining the fraud-prevention adjustment? If so, why?

6. As described in paragraphs (c)(1), (d)(1), and (e)(1) of proposed appendix B to Regulation II, respectively, the Board proposes to round the base component to the nearest tenth of one cent, the

ad valorem

component to the nearest quarter of one basis point, and the fraud-prevention adjustment to the nearest tenth of one cent. Further, as described in paragraph (c)(3) of proposed appendix B to Regulation II, in determining the base component, the Board proposes to round the transaction-weighted average of per-transaction allowable costs (excluding fraud losses) across covered issuers to the nearest tenth of one cent. Do these rounding conventions provide an appropriate degree of precision? If not, what alternative rounding conventions should the Board adopt?

7. As described in paragraphs (c) through (e) of proposed appendix B to Regulation II, the Board would determine the base component,

ad valorem

component, and fraud-prevention adjustment for an applicable period using data reported on lines 1a, 3a, 5a, 5a.1, and 8b of the Debit Card Issuer Survey (FR 3064a).

a. Are there any reporting challenges or data quality issues associated with these line items of which the Board should be aware? If so, how could the Board address these challenges or issues?

b. Should the Board amend § 235.8 of Regulation II to specify that a covered issuer is required to retain records supporting the data that the covered issuer reports on the Debit Card Issuer Survey? Would this record retention requirement be duplicative of any existing recordkeeping requirements for covered issuers? If not, what would be the estimated additional annual burden of this requirement, in terms of hours and cost, for covered issuers?

8. As described in section VI, with one exception, the Board proposes that the revisions would take effect on the first day of the next calendar quarter that begins at least 60 days after the final rule is published in the

Federal Register

. Would this proposed effective date provide sufficient notice to covered issuers, payment card networks, and other industry stakeholders to prepare for the initial changes to the base component,

ad valorem

component, and fraud-prevention adjustment?

9. As stated in paragraph (f) of proposed appendix B to Regulation II, going forward, the Board would publish the base component,

ad valorem

component, and fraud-prevention adjustment in the

Federal Register

no later than March 31 for an applicable period beginning July 1. Would this timeline provide sufficient notice to covered issuers, payment card networks, and other industry stakeholders to prepare for changes to these amounts? Should the Board increase or decrease the period between publication of these values and the beginning of the next applicable period?

10. Proposed comments 235.3(b)-4 and 235.4(b)-1 would provide that, for purposes of determining in which two-year period a debit card transaction is considered to be performed, a debit card transaction is considered to be performed on the date on which it is settled on an interbank basis. Is this proposed convention sufficiently clear? For example, should the Board specify which time zone is controlling for purposes of determining the date on which a transaction is settled on an interbank basis? Should the Board adopt an alternative standard, such as considering a transaction to be performed on the date on which the cardholder presents the debit card to the merchant for payment?

11. Would any of the proposed technical revisions described in section V, which are generally intended to make Regulation II clearer, create unintended consequences?

12. Does the Board's economic analysis of the proposal, set forth in section VIII.A, appropriately describe the likely impact of the proposal on various participants in the debit card market? Are there additional impacts of the proposal that the Board has not considered?

VIII. Regulatory Analyses

A. EFTA Section 904(a) Analysis

1. Statutory Requirement

Section 904(a)(2) of the EFTA requires the Board, in prescribing regulations to carry out the purposes of EFTA section 920, to prepare an economic analysis that considers the costs and benefits to financial institutions, consumers, and other users of electronic fund transfers. The analysis must address the extent to which additional paperwork will be required, the effect upon competition in the provision of electronic fund transfer services among large and small financial institutions, and the availability of such services to different classes of consumers, particularly low-income consumers. EFTA section 904(a)(2) also requires, to the extent practicable, the Board to demonstrate that the consumer protections of the proposed regulations outweigh the compliance costs imposed upon consumers and financial institutions. The Board interprets these requirements as applying with respect to both proposed and final rules implementing EFTA section 920.

In analyzing the potential effects of the proposal, the Board considered predictions of economic theory, information regarding debit card industry structure and practices, and issues raised during the original Regulation II rulemaking. The analysis also incorporates the experience of debit card industry participants since the current interchange fee cap was adopted in 2011.

2. Cost/Benefit Analysis

(a) Effects on Merchants

85

85

The Board interprets “other users of electronic fund transfer services” in EFTA section 904(a)(2) to refer primarily to merchants.

The Board believes that the primary way in which the proposal would impact merchants is by lowering their costs of accepting debit card transactions. The proposal would generally decrease the interchange fee paid by an acquirer (

i.e.,

a merchant's depository institution) on an average transaction performed using a debit card issued by a covered issuer, which would in turn decrease a merchant's costs by decreasing the merchant discount that the merchant pays to its acquirer for a debit card transaction.

86

Although the precise extent to which acquirers would pass on savings from lower debit card interchange fees to merchants may vary, competition between acquirers in the industry should generally result in acquirers passing on savings from lower

interchange fees to their merchant customers.

87

86

Data collected by the Board show that, since adoption of the current interchange fee cap, actual per-transaction interchange fees for transactions subject to the interchange fee standards have been close in value to the amount permitted under the interchange fee cap. Thus, the Board expects that the proposed revisions to the interchange fee cap will directly lower per-transaction interchange fees for most transactions subject to the interchange fee standards.

87

The extent to which an acquirer passes on savings from lower interchange fees to a merchant may depend on many factors, including the merchant's type and size.

Merchants that experience a decrease in the costs of accepting debit card transactions may pass on some or all these savings to consumers in the form of lower prices, foregone future price increases, or improved products or services.

88

The extent to which merchants would pass on such savings to consumers may depend on many factors. For example, merchants in more competitive markets would be likely to pass on more of their cost savings to consumers compared with merchants facing less competition.

88

In addition, merchants may use savings from lower costs of accepting debit card transactions to enhance their operations, for example, by adding staff, improving their facilities, or implementing new technology.

Measuring the extent to which merchants pass on cost savings to consumers, including any decrease in the costs of accepting certain forms of payment, is generally difficult.

89

Efforts to measure the extent to which merchants passed on to consumers any savings associated with the decrease in the costs of accepting debit card transactions in the period following the adoption of the current interchange fee cap in 2011 have yielded a wide range of results. For example, in response to a survey conducted soon after the introduction of the interchange fee cap, merchants did not consistently report making adjustments to their prices in response to the interchange fee cap.

90

By contrast, later research efforts analyzing data from longer time periods found evidence that merchants passed on to consumers a portion of their debit card acceptance costs (

e.g.,

by adjusting their prices) and that the degree of pass-through depended on merchant size.

91

89

Potential challenges include (i) a lack of detailed price and cost data at the merchant level, (ii) contemporaneous changes in other costs for merchants, (iii) the small magnitude of cost variation due to changes in interchange fees relative to total price, and (iv) asymmetric price stickiness in the short term, meaning that merchants are more likely to increase prices in response to cost increases than to lower prices in response to cost decreases. For an overview of research looking to measure merchant cost pass-through,

see

Howard Chang, David S. Evans & Daniel D. Garcia Swartz,

The Effect of Regulatory Intervention in Two-Sided Markets: An Assessment of Interchange-Fee Capping in Australia,

4 Review of Network Economics 328 (2005),

https://doi.org/10.2202/1446-9022.1080.

90

See

Wang, Zhu, Scarlett Schwartz, & Neil Mitchell,

The Impact of the Durbin Amendment on Merchants: A Survey Study,

100 Federal Reserve Bank of Richmond Economic Quarterly 183 (2014),

https://www.richmondfed.org/-/media/RichmondFedOrg/publications/research/economic_quarterly/2014/q3/pdf/wang.pdf.

91

See, e.g.,

Vladmir Mukharlyamov & Natasha Sarin,

Price Regulation in Two-Sided Markets: Empirical Evidence from Debit Cards

(last rev. Nov. 28, 2022) (unpublished manuscript),

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3328579;

Efraim Berkovich & Zheli He,

Rewarding the Rich: Cross Subsidies from Interchange Fees

(Hispanic Leadership Fund, May 3, 2022),

https://hispanicleadershipfund.org/wp-content/uploads/2022/05/HLF_Report_RewardingTheRich-InterchangeFees_03May22.pdf.

Finally, the decrease in costs of accepting debit card transactions may incentivize some merchants that until now have not accepted debit cards as a form of payment to begin doing so. In particular, while debit card acceptance is already high for most in-person transactions, the proposal may encourage greater adoption of debit cards in market segments where acceptance may be lower, such as card-not-present (

e.g.,

ecommerce) transactions. Another market segment for which merchants may increase debit card acceptance are small-dollar purchases because, for this market segment, the proposed decrease in the base component would substantially reduce debit card acceptance costs as a proportion of the transaction value. Faced with lower debit card acceptance costs, some merchants may also look to provide incentives to their customers, or otherwise steer them, to pay with debit cards over alternative payment methods.

(b) Effects on Debit Card Issuers

92

92

The Board interprets “financial institutions” in EFTA section 904(a)(2) to refer primarily to issuers of debit cards.

The Board believes that the proposal would have a direct effect on covered issuers but would not directly affect debit card issuers exempt from the interchange fee cap (exempt issuers).

The primary way in which the proposal would affect covered issuers would be by lowering their revenue from debit card transactions. In particular, covered issuers' interchange fee revenue would decline as the proposal would decrease the average interchange fee they collect on debit card transactions subject to the interchange fee standards. This reduction in covered issuers' total debit card interchange fee revenue could be offset to some extent by the likely continued growth in total debit card volume, with the offset potentially varying between different issuers. Debit card popularity has grown substantially since the current interchange fee cap was adopted; over this period, debit cards have become the most commonly used noncash payment method in the United States.

93

As noted above, further reduction in interchange fee levels may support continued growth in debit card volumes to the extent that more merchants accept debit cards as a form of payment or encourage their customers to use debit cards.

93

Board of Governors of the Federal Reserve System,

The Federal Reserve Payments Study: 2022 Triennial Initial Data Release, https://www.federalreserve.gov/paymentsystems/fr-payments-study.htm.

Faced with lower interchange revenue from debit card transactions, covered issuers may offset some or all lost interchange fee revenue through a combination of customer fee increases and issuer cost reductions (

e.g.,

improvements to transaction-processing efficiency).

94

Depending on a variety of factors, such adjustments may make covered issuers' checking account and debit card programs less attractive to consumers. In response to these adjustments, consumers may switch to checking account or debit card programs offered by exempt issuers, or to alternative payment methods such as credit cards and digital payment methods, potentially leading to a further reduction in covered issuers' revenues from debit cards.

95

94

An issuer seeking to reduce costs may reduce transaction-processing costs and/or other types of costs. Under the proposed approach, the former could result in a reduction to the interchange fee cap once data collected by the Board show a reduction in the transaction-weighted average of per-transaction transaction-processing costs across covered issuers. Although another way in which covered issuers could offset a loss in interchange fee revenue could be through reductions in debit card reward programs, data collected by the Board show that following the adoption of the current interchange fee cap, covered issuers significantly limited or eliminated such programs, suggesting that issuers may not be able to reduce such programs much further.

See generally

Board of Governors of the Federal Reserve System,

Regulation II (Debit Card Interchange Fees and Routing): Reports and Data Collections, https://www.federalreserve.gov/paymentsystems/regii-data-collections.htm.

95

In addition, the reduction in covered issuers' interchange fee revenue could theoretically lead some covered issuers, particularly those serving niche market segments, such as high net-worth individuals, to downsize or potentially discontinue their debit card programs.

The experience following the introduction of the current interchange fee cap in 2011 provides information about how covered issuers may adjust their debit card programs in response to the proposal. Research shows that the adoption of the current interchange fee cap resulted in covered issuers increasing customer fees on checking accounts more than they otherwise would have, although these increases offset the reduction in interchange fee revenue only partially.

96

Furthermore,

the continued growth in debit card popularity since the adoption of Regulation II, and the lack of a pronounced shift by consumers from covered issuers' to exempt issuers' debit card programs, suggest that such fee increases and other adjustments to checking accounts and debit card programs offered by covered issuers did not make them substantially less attractive to consumers.

97

Finally, the Board is not aware of any evidence that the adoption of the current interchange fee cap led any covered issuers to discontinue their debit card programs.

96

Benjamin S. Kay, Mark D. Manuszak & Cindy M. Vojtech,

Competition and Complementarities in

Retail Banking: Evidence from Debit Card Interchange Regulation,

34 Journal of Financial Intermediation 91 (2018); Mark D. Manuszak & Krzysztof Wozniak,

The Impact of Price Controls in Two-Sided Markets: Evidence from US Debit Card Interchange Fee Regulation,

Finance and Economics Discussion Series 2017-074,

https://www.federal6reserve.gov/econres/feds/files/2017074pap.pdf;

Vladmir Mukharlyamov & Natasha Sarin,

Price Regulation in Two-Sided Markets: Empirical Evidence from Debit Cards

(last rev. Nov. 28, 2022) (unpublished manuscript),

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3328579.

97

See generally

Board of Governors of the Federal Reserve System,

Regulation II (Debit Card Interchange Fees and Routing): Reports and Data Collections, https://www.federalreserve.gov/paymentsystems/regii-data-collections.htm.

By contrast, the proposal would not directly or, the Board believes, indirectly affect exempt issuers (

i.e.,

those with consolidated assets under $10 billion).

98

The experience following the introduction of the current interchange fee cap in 2011 provides information about whether exempt issuers are likely to be affected by the proposal. First, the adoption of the current interchange fee cap and the statutory exemptions for certain issuers and debit card transactions led all debit card networks to adopt pricing structures with different interchange fees for covered and exempt issuers. Second, data collected by the Board demonstrate that average per-transaction interchange fees for exempt issuers across all payment card networks did not decline after the current interchange fee cap was introduced in 2011 and have not declined since then.

99

Average per-transaction interchange fees for exempt issuers have remained at a level substantially higher than average per-transaction interchange fees for covered issuers, with the latest data collected by the Board documenting that average per-transaction interchange fees for exempt issuers increased in 2020 and 2021.

100

98

The Board collects and reports annual information from payment card networks about their interchange fees for transactions subject to and exempt from the interchange fee cap.

See

Board of Governors of the Federal Reserve System,

Regulation II (Debit Card Interchange Fees and Routing): Average Debit Card Interchange Fee by Payment Card Network, https://www.federalreserve.gov/paymentsystems/regii-average-interchange-fee.htm.

The Board also annually publishes lists of covered and exempt institutions that issuers, payment card networks, and other market participants can use to determine which issuers qualify for the small issuer exemption.

See

Board of Governors of the Federal Reserve System,

Interchange Fee Standards: Small Issuer Exemption, https://www.federalreserve.gov/paymentsystems/regii-interchange-fee-standards.htm.

99

See

Board of Governors of the Federal Reserve System,

Regulation II (Debit Card Interchange Fees and Routing): Average Debit Card Interchange Fee by Payment Card Network, https://www.federalreserve.gov/paymentsystems/regii-average-interchange-fee.htm.

100

See id.

(c) Effects on Consumers and Availability of Services to Different Classes of Consumers

As discussed above in the context of effects on merchants and debit card issuers, the proposal could affect consumers in two main ways. On the one hand, consumers could benefit if merchants pass on savings associated with the decrease in costs of accepting debit card transactions in the form of lower prices, forgone future price increases, or improvements in product or service quality. On the other hand, consumers could be negatively affected if covered issuers increase fees on debit cards or checking accounts, or make other adjustments that make these products less attractive to consumers.

The net effect on consumers, both individually and in the aggregate, will depend on which of these two effects predominates, which would in turn depend on many factors and is thus difficult to predict. As noted above, merchants in more competitive markets would likely pass on a larger portion of their cost savings to consumers. In a similar way, in response to declines in interchange fee revenue, covered issuers in more competitive markets would be less likely to increase fees or make other changes that negatively affect consumers. Covered issuers that face strong competition from exempt issuers may be less likely to raise fees, as doing so could increase the probability that customers switch to these competing institutions.

In addition, the effect of the proposal could differ between particular classes of consumers in several ways. First, if the proposal results in merchants further increasing debit card acceptance (

e.g.,

for card-not-present transactions), consumers' ability to make such payments could increase, generating benefits to consumers without access to alternative non-cash payment methods, such as credit cards. Second, if the proposal results in covered issuers increasing fees, banking services could become less accessible to lower-income consumers who may be more sensitive to such fees.

101

101

However, the Board notes that the unbanked rate in the United States has been steadily declining over time, including after the introduction of the current interchange fee cap in 2011. According to the data collected by the Federal Deposit Insurance Corporation, the rate of unbanked in the population fell from 8.2 percent in 2011 to an all-time low of 4.5 percent in 2021.

See

Federal Deposit Insurance Corporation,

2021 FDIC National Survey of Unbanked and Underbanked Households, https://www.fdic.gov/analysis/household-survey/2021report.pdf.

(d) Additional Paperwork

The proposal would not substantively alter the reporting and recordkeeping requirements that § 235.8 of Regulation II imposes on covered issuers and networks, and would not alter the recordkeeping requirement for exempt issuers.

102

Regulation II does not impose any reporting or recordkeeping requirements on consumers or merchants.

102

However, the Board requests comment on whether § 235.8 of Regulation II should be amended to specify that a covered issuer is required to retain records supporting the data that the covered issuer reports on the Debit Card Issuer Survey.

See

section VII,

supra

(Question 6(b)).

(e) Effects Upon Competition in the Provision of Electronic Banking Services

103

103

Although EFTA section 904(a)(2) requires the Board to consider the effects upon competition in the provision of electronic banking services among large and small financial institutions, the Board is considering the impact of the final rule on competition generally, including competition between large and small financial institutions.

The proposal could affect competition between covered and exempt issuers by reducing the average per-transaction debit card interchange fee received by covered issuers without affecting the amount received by exempt issuers. As noted above, the competitive effect of any adjustments made by covered issuers to their fee structures in response to the reduction in interchange fee revenue would depend on the degree of substitution between exempt and covered issuers. Research suggests that competition between smaller and larger depository institutions is weaker than competition between large depository institutions or competition between small depository institutions, likely because these institutions serve different customer bases.

104

In addition,

data collected by the Board indicates that the proportion of debit card transactions attributable to covered and exempt issuers did not significantly change before and after the adoption of the current interchange fee cap.

105

In light of this evidence, the Board does not expect the proposal to have a significant impact on competitive dynamics between the two groups of issuers. The Board further does not believe that the proposal would affect competition between debit card networks.

104

See, e.g.,

Robert M. Adams, Kenneth P. Brevoort & Elizabeth K. Kiser,

Who Competes with Whom? The Case of Depository Institutions,

55 Journal of Industrial Economics 141 (2007); Andrew M. Cohen & Michael J. Mazzeo,

Market Structure and Competition Among Retail Depository Institutions,

89 Review of Economics and Statistics 60 (2007); Timothy H. Hannan & Robin A. Prager,

The Profitability of Small Single-Market Banks in an Era of Multi-Market Banking,

33 Journal of Banking and Finance 263 (2009).

105

See generally

Board of Governors of the Federal Reserve System,

Regulation II (Debit Card Interchange Fees and Routing): Reports and Data Collections, https://www.federalreserve.gov/paymentsystems/regii-data-collections.htm.

(f) Consumer Protection and Compliance Costs

106

106

To the extent that the interchange fee standards and fraud-prevention adjustment constitute consumer protections, the Board believes that the aim of those protections is broadly to benefit consumers, rather than to address specific consumer rights. As such, the Board has, to the extent practicable, considered broadly whether the overall benefits of the proposed revisions to consumers outweigh other costs imposed on consumers or financial institutions.

Based on the analysis above, the Board cannot, at this time, determine whether the potential benefits of the proposal to consumers exceed the possible costs imposed on consumers and financial institutions. As described above, the proposal may yield benefits for consumers, but the magnitude of these benefits will depend on the behavior of various participants in the debit card industry. The proposal may also impose costs on consumers and financial institutions, but the net effect on any individual or entity will depend on its particular circumstances. Because the overall effects of the proposal on consumers and on financial institutions are dependent on a variety of factors, the Board cannot determine at this time whether the potential benefits of the proposal to consumers exceed the possible costs imposed on consumers and financial institution.

B. Statutory Considerations for Proposed Revisions to the Interchange Fee Standards

In prescribing regulations to establish interchange fee standards, EFTA section 920(a)(4) requires the Board to consider the functional similarity between debit card transactions and checking transactions that are required within the Federal Reserve bank system to clear at par.

107

107

The same provision of the statute additionally requires the Board to (i) distinguish between certain types of costs incurred by debit card issuers and (ii) consult with certain other agencies. The allowable costs that the Board considered in establishing the interchange fee standards are discussed in section III.A,

supra.

The interagency consultation requirement is discussed in section VIII.D,

infra.

The Board considered the functional similarity between debit card transactions and checking transactions when the Board adopted Regulation II, and this analysis informed certain decisions the Board made when the Board established the interchange fee standards.

108

The similarities noted by the Board included the fact that both types of transactions result in a debit to an asset account; both involve electronic processing and deposit; both involve processing fees paid by merchants to banks and other intermediaries; and both have similar settlement timeframes. The differences noted by the Board included the closed nature of debit card systems compared to the open check clearing and collection system (and limitations on routing a debit card transaction based on the set of networks the issuer has enabled or that the merchant accepts); the payment authorization that is an integral part of debit card transactions (but not check transactions), which generally guarantees that the transaction will not be returned for insufficient funds or certain other reasons (

e.g.,

a closed account); processing and collection costs incurred by the issuer (analogous to the payor's bank) for debit card transactions but not for check transactions; par clearance in the check system; payee deposit and availability; the amount of time in which a payor may reverse a transaction (which is much longer in the case of a debit card transaction compared to a check); and the increasing popularity of debit card payments (and declining use of check).

108

See

76 FR 43393, 43399 (July 20, 2011). For example, similarities and differences between debit card transactions and check transactions were factors in the Board's decision to include or exclude from allowable costs a number of types of costs incurred by debit card issuers.

See

76 FR at 43428 (July 20, 2011).

The Board has reviewed its analysis from 2011 regarding the functional similarity between debit card transactions and checking transactions and believes that the factual predicates underlying that analysis remain unchanged. For that reason, the Board continues to believe that its prior analysis remains sound.

C. Statutory Considerations for Proposed Revisions to the Fraud Prevention Adjustment

109

109

All data used in this section have been sourced from the Board's Debit Card Issuer Surveys and Payment Card Network Surveys. Reports and data tables published by the Board, as well as notes regarding the figures cited in this section, may be found on the Board's website.

See

Board of Governors of the Federal Reserve System,

Regulation II (Debit Card Interchange Fees and Routing): Reports and Data Collections, https://www.federalreserve.gov/paymentsystems/regii-data-collections.htm.

1. Statutory Requirement

EFTA section 920(a)(5)(B)(ii) requires the Board, in prescribing regulations for any fraud-prevention adjustment, to consider (i) the nature, type, and occurrence of fraud in debit card transactions; (ii) the extent to which the occurrence of fraud depends on whether authorization in a debit card transaction is based on signature, personal identification number (PIN), or other means; (iii) the available and economical means by which fraud on debit card transactions may be reduced; (iv) the fraud-prevention and data-security costs expended by each party involved in debit card transactions (including consumers, persons who accept debit cards as a form of payment, financial institutions, retailers, and payment card networks); (v) the costs of fraudulent transactions absorbed by each party involved in such transactions (including consumers, persons who accept debit cards as a form of payment, financial institutions, retailers, and payment card networks); (vi) the extent to which interchange fees have in the past reduced or increased incentives for parties involved in debit card transactions to reduce fraud on such transactions; and (vii) such other factors as the Board considers appropriate.

110

The Board has considered the factors set forth in EFTA section 920(a)(5)(B)(ii) in light of the latest data from covered issuers from 2021 and the cumulative data collected from covered issuers since the original Regulation II rulemaking.

110

EFTA section 920(a)(5)(B)(ii) does not specify precisely how the Board should evaluate each of these factors.

When the Board adopted the current fraud-prevention adjustment of 1.0 cent, the Board focused on one factor in particular: the fraud-prevention costs expended by various parties involved in debit card transactions.

111

As discussed below, the Board believes that all parties continue to incur fraud-prevention costs and that the Board's proposed methodology for determining the fraud-prevention adjustment appropriately considers those costs.

111

See

77 FR 46258, 46265 (Aug. 3, 2012). The Board also considered the costs of losses absorbed by different parties to fraudulent transactions when it developed the fraud-prevention standards, which the Board does not propose to revise.

See

77 FR at 46270. The Board additionally considered certain other factors in connection with the overall structure of the fraud-prevention adjustment, such as the incentives created by the adjustment.

See

76 FR 43477, 43483 (July 20, 2011).

Notably, as described below, data reported by covered issuers since the adoption of Regulation II show that the incidence, types, and relative rates of absorption of fraud losses have changed. As noted in section III.B,

supra,

in connection with the Board's proposed revisions to the

ad valorem

component, the Board has observed an overall increase in fraud losses to all parties related to covered issuer transactions, but the share of such fraud losses absorbed by covered issuers has declined. Changes in the median ratio of issuer fraud losses to transaction value among covered issuers would be reflected in the Board's proposed revisions to the

ad valorem

component.

2. Factors

(a) Nature, Type, and Occurrence of Fraud

With respect to covered issuer transactions, fraud losses to all parties as a share of transaction value increased from 9.0 basis points in 2009 to 17.5 basis points in 2021, and have displayed an upward trend since 2011 (the first year for which the Debit Card Issuer Survey was mandatory). In 2021, the most commonly reported and highest-value fraud types for covered issuer transactions were card-not-present fraud, lost and stolen card fraud, and counterfeit fraud. Card-not-present fraud, at 8.6 basis points of transaction value, accounted for almost half of overall fraud in 2021. Lost and stolen card fraud accounted for 4.6 basis points of transaction value, and counterfeit card fraud accounted for 3.4 basis points of transaction value. In 2009, counterfeit card fraud, card-not-present fraud, and lost and stolen card fraud accounted for 4.3 basis points, 1.8 basis points, and 1.5 basis points, respectively, as a share of transaction value.

(b) Extent to Which the Occurrence of Fraud Depends on Authentication Mechanism

Overall fraud incidence for covered issuer transactions approximately doubled from 2009 to 2021, and dual-message (traditionally mainly signature-authenticated) debit card transactions exhibited a considerably higher fraud incidence than single-message (traditionally mainly PIN-authenticated) debit card transactions, as has been the case since 2009. In 2021, 0.11 percent of covered issuer transactions were reported as fraudulent. Covered issuers reported as fraudulent 0.13 percent of dual-message transactions and 0.02 percent of single-message transactions. Across all covered issuer transactions, the average loss for dual-message transactions was 8.6 cents per transaction and represented 17.5 basis points of transaction value. For single-message transactions, the average loss was 1.9 cents per transaction and represented 4.2 basis points of transaction value. In 2009, 0.04 percent of covered issuer transactions were reported as fraudulent. The average loss for dual-message transactions was 4.7 cents per transaction and represented 12.7 basis points of transaction value. The average loss for single-message transactions was 1.3 cent per transaction and represented approximately 3.2 basis points of transaction value.

The differential in fraud losses between single- and dual-message transactions can be explained in part by differences in the use of single- and dual-message networks for card-not-present transactions. As noted above, card-not-present fraud accounted for almost half of overall fraud on covered issuer transactions in 2021, and single message networks continue to be used relatively rarely for card-not-present transactions. In 2021, the percentage of card-not-present transactions out of the total number and value of all debit card transactions processed over single-message networks, at 6.1 and 6.7 percent, respectively, continued to be significantly lower than the analogous percentages for dual-message networks, at 44.2 and 60.7 percent, respectively.

(c) Available and Economical Means by Which Fraud May Be Reduced

In response to the Board's voluntary survey of covered issuers concerning transactions performed in 2009, covered issuers identified several categories of activities used to detect, prevent, and mitigate fraudulent debit card transactions, including transaction monitoring; merchant blocking; card activation and authentication systems; PIN customization; system and application security measures, such as firewalls and virus protection software; and ongoing research and development focused on making fraud-prevention activities more effective.

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Since that time, the Board identified tokenization as an important emerging fraud-prevention technique, and added it to the list of fraud-prevention activities starting from the 2019 Debit Card Issuer Survey.

113

112

See

77 FR 46258, 46261 (Aug. 3, 2012).

113

See

84 FR 65815 (Nov. 29, 2019).

(d) Fraud-Prevention Costs Expended by Parties Involved in Debit Card Transactions

When the Board adopted current § 235.4 in 2012, the Board reviewed fraud-prevention costs expended by parties involved in debit card transactions.

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The Board continues to believe that all parties involved in debit card transactions incur fraud-prevention costs. For example, some consumers routinely monitor their accounts for unauthorized debit card purchases, but the opportunity cost of consumers' time to monitor their account is difficult to put into monetary terms. Merchants and acquirers incur costs for fraud-prevention tools, such as terminals that enable merchants to use various card- and cardholder-authentication mechanisms, address verification, geolocation services, and data-encryption technologies. Merchants may purchase services from third parties and may also develop their own fraud-prevention tools. In addition, merchants may also take steps and incur costs to secure data and comply with Payment Card Industry Data Security Standards (PCI-DSS) and other fraud-prevention standards.

114

See

77 FR at 46261-62.

As discussed in section IV of this preamble,

supra,

the Board has collected data from covered issuers concerning the costs incurred by covered issuers in connection with debit card transactions performed in calendar years 2011, 2013, 2015, 2017, 2019, and 2021. These data show that fraud-prevention costs incurred by covered issuers have risen since 2009, such that the median per-transaction fraud-prevention costs among covered issuers was 1.3 cents in 2021.

(e) Costs of Fraudulent Transactions Absorbed by Different Parties Involved in Fraudulent Transactions

Most fraud losses associated with covered issuer transactions in 2021 were borne by covered issuers and merchants. In 2009, covered issuers, merchants, and cardholders bore 61.2 percent, 38.3 percent, and 0.5 percent of these fraud losses, respectively. In 2021, covered issuers, merchants, and cardholders bore 33.5 percent, 47.0 percent, and 19.5 percent of fraud losses, respectively. This shift reflects a number of factors. First, card-not-present transactions grew from 9.8 percent of covered issuer transactions in 2009 to 32.1 percent of covered issuer transactions in 2021. Second, card-not-present fraud accounted for almost half of overall fraud in 2021, and merchants bear a greater share of fraud losses for this type of transactions (almost two-thirds of card-not-present fraud in 2021). Third, merchants absorbed an increasing share of fraud losses across almost all transaction categories and fraud types in

2021, relative to 2009. For example, merchants' share of fraud losses has also increased over time for single-message transactions, from around 4 percent in 2009 to 31.9 percent in 2021.

(f) Extent to Which Interchange Transaction Fees Have in the Past Affected Fraud-Prevention Incentives

In 2012, the Board noted that issuers have a strong incentive to protect cardholders and reduce fraud independently of interchange fees, and that competition among issuers for cardholders suggested that protecting cardholders from fraud is good business practice for issuers. At the time, merchants commented that, historically, higher interchange fee revenue for signature debit relative to PIN debit may have encouraged issuers to promote the use of signature debit over PIN debit, even though signature debit had substantially higher rates of fraud.

115

115

77 FR at 46262.

The Board continues to believe that covered issuers have an incentive to protect cardholders and reduce fraud, despite a reduction in the proportion of fraud losses borne by covered issuers and an increase in the proportion born by cardholders. Covered issuers continue to bear more than a quarter of all fraud losses, which means that their efforts to reduce fraud rates translate directly into lower fraud losses. Moreover, competition with other debit card issuers continues to provide downward pressure on the proportion of fraud losses that an issuer passes on to its cardholders, as passing on more fraud losses to cardholders increases the likelihood that they switch to competing issuers. Notwithstanding the adoption of the interchange fee standards and the fraud-prevention adjustment, the median per-transaction fraud-prevention costs among covered issuers has risen since 2009, to 1.3 cents per transaction in 2021.

Furthermore, data collected by the Board show that interchange fees on most transactions subject to the interchange fee cap are at or close to the cap, including for different authentication methods, which suggests that covered issuers have no incentives to promote the use of networks or authentication mechanisms that have higher rates of fraud.

D. Interagency Consultation

In addition to the economic analysis provided above, EFTA section 904(a)(2) requires the Board to consult with the other agencies that have enforcement authority under the EFTA on any rulemakings related to EFTA section 920.

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