The Changing Environment of Debit Cards

November 11, 2004

The debit card as a payment mechanism has experienced double-digit growth for more than a decade and debit cards remain the fastest-growing consumer payment vehicle in comparison to cash, checks, and credit cards. In 2003 Nilson reported that VISA and MasterCard signature debit card transactions exceeded credit card transactions for the first time.

With the implementation of the Wal-Mart settlement terms and the subsequent reduction in VISA’s and MasterCard’s interchange reimbursement fees, financial institutions are prompted to reassess their debit card financial models. Other forces also are at work within the payment systems arena. Like the financial services industry itself, the EFT network marketplace has undergone a tremendous amount of change, including consolidation, increased processing at publicly owned third-party transaction processors, blurred lines between regional and national EFT networks, and non-bank ownership.

EFT network consolidation began in the 1980s and continues to occur today. For example, the top four EFT networks (Star, NYCE, MAC, and Honor) had approximately a 54% transaction volume market share in 1995. In 2003, the top four EFT networks (Star, Interlink, NYCE, and Pulse) had approximately a 76% transaction volume market share.

On-bank entities now control the majority of the EFT networks that have aligned themselves more with merchants than with issuers. As a result, the financial industry’s leadership, oversight, and most of all, their control over the payment at the POS, is being threatened. More specifically, financial institution ownership of the EFT networks declined to 29% in 2001 from 91% in 1996. Such a “merchant-centric” versus “financial institution-centric” shift causes financial institutions to re-evaluate their ATM and POS network relationships with respect to acceptance for their cardholders and to maximize revenues and expenses as appropriate. The most aggressive player in the market was Concord EFS, which owned the Star Systems EFT network (the largest regional network in the nation). Star Systems, ultimately Concord EFS, acquired a number of networks over the past 10 years including, MAC and Honor. Today, Concord EFS and First Data Corp. are a merged entity that carries the First Data Corp. brand.

It is imperative that financial institutions examine all of their EFT Network and processing relationships in order to adopt the right mix of cardholder/network acceptance, processing services, and profitability.

An important element of such an examination must consider the type of debit card. There are two major types of debit cards in the market: a signature-based or “offline” debit card and a PIN-based or “online” debit card. Today, the majority of debit cards issued by financial institutions are multi-functional and provide the capability to conduct ATM, signature debit, and PIN debit transactions. In the debit card arena, the distinction in card functionality at the point of sale is important because of the interchange reimbursement fee differential (approximately 80 basis points) that exists between signature debit and PIN debit, which is passed on to card-issuing financial institutions.

For a debit-card-issuing institution, obtaining the card relationship starts when it attracts a new checking account or share draft relationship. Price and convenience are the driving forces that prompt consumers to open a new checking account (typically free). There are basically two variations: free checking and free checking with direct deposit. Both of these typically offer a free debit card to new accounts. Today, institutions typically use the consumers’ non-sufficient funds (NSF) histories to evaluate the risk potential of debit cardholders. Consequently, if consumers qualify for a checking account, then they also qualify for a debit card. The goal of the financial institution is to get as many debit cards into the hands of their checking accountholders as possible. Typically, financial institutions establish a goal of 80% penetration. In June of this year, VISA reported an average of 70% debit card penetration rate for its card-issuing financial institutions.

Although penetration strategies are important, financial institutions also must execute activation and usage strategies to maximize revenue. Commonly with a mass issuance debit card strategy, there arise concerns of high inactivity rates and related costs of unused cards. Therefore, it is imperative that financial institutions support their issuance efforts with strong activation programs. Industry statistics suggest that financial institutions work to attain an activation goal of 65%. In June 2004, VISA reported that its card issuers are averaging 60% average activation rate.

When viewed as a collective unit, debit card users display a higher degree of loyalty than other types of delivery channel users. As a result, they are receptive and attractive targets for cross-sales promotions, especially loan product sales. Financial institutions can also strengthen their customer/member relationship when debit cards tie in recurring payments, bill payments, and overdraft protection. Just as debit cards have the potential to reinforce customer/member relationships, the absence of a debit card offering puts a financial institution at a competitive disadvantage that may result in the loss of the customer/member.

In terms of household profitability, debit card users generate relatively low overall household profit when compared to other delivery channel users. However, they do drive more total profit than active check writers. It also should be pointed out that not all debit cardholders are equal. When segmented by the number of transactions they conduct on a monthly basis, those debit cardholders that conduct more than 25 transactions a month (high-volume users) are 1.7 times more profitable on a household level than the average debit card user because of their additional fee income generation and their high-balance loan product usage.

The challenge that financial institutions are facing is to increase usage among low- and moderate-volume debit cardholders. If successful, financial institutions can improve overall profitability of those lower transaction level cardholders. When considering usage strategies, financial institutions must be aware of consumer demographics. Usually the consumer segment composition of an institution’s customer/member franchise dictates the extent of debit card use. Through a target marketing initiative that includes a comprehensive educational program, financial institutions can communicate the key benefits of debit card usage and address any misconceptions and concerns consumers may have related to the card. To leverage debit card relationships and improve cardholder earnings, financial institutions should strive to influence cardholder behavior to increase usage to 12 signature debit transactions per month per active card. Credit unions also need to understand and communicate to their customers/members how debit cards can be used to make online purchases, purchase stored-value cards, make recurring bill payments, and make micro-payments.

Swipe-and-sign versus PIN transactions has continued to be a pressing question in the retail marketplace, especially when considering the fluctuations in interchange rates since the Wal-Mart settlement. However, today with high-purchase ticket items, the uncapped signature-debit pricing structure over PIN-based debit still provides financial institutions a monetary incentive to promote signature transactions. Issuers should realize that currently consumers do not exhibit a “clear” preference for conducting an offline signature-based debit card transaction over an online PIN-based debit card transaction.

When it comes to choosing between PIN and signature debit, consumers do suggest that PIN-based transactions are faster because they do not have to sign a receipt. However, consumers are willing to sign debit card receipts if they are given an incentive or disincentive to do so. Some financial institutions have been successful by employing the following strategies.

Rewards Programs Active debit cardholders indicate that the availability of a rewards program could encourage them to increase their use of their debit cards for retail purchases. These consumers respectively prefer a cash-back rebate program and a redeemable points accumulation program as the rewards program of choice. However, they are generally not amenable to paying an annual fee to participate in such a rewards program.

Online PIN-Debit Fee Another strategy imposed by some financial institutions is an online PIN-debit fee. Such a fee (typically $.25 to $1.00 per debit card PIN-transaction) is designed to encourage more offline signature-debit transactions and discourage online PIN-debit transactions as well as improve profitability for PIN transactions.

In summary, a debit card is a key contributor to the overall success of financial institution from several perspectives:

A debit card is a source of incremental non-interest revenue. A debit card is a vehicle to solidify member relationships and to some degree insulate core deposits from disintermediation. A debit cardholder is an ideal “cross-sales” candidate, especially for loans. If an institution can leverage such sales opportunities, it can increase the value of the relationship (i.e., higher household profitability). The debit card category is expanding into new acceptance channels and emerging markets such as recurring bill payments, quick service restaurants, and e-commerce. A debit card program, when combined with an ATM deployment strategy, will help satisfy members that require a self-service model. This executive summary is from a white paper entitled “The Changing Environment of Debit Cards in an Evolving Payment Systems Market” (October 2004), produced by Raddon Financial Group and Card Services for Credit Unions. For access to the white paper, contact Dan McGowan of the Raddon Financial Group at dmcgowan@raddon.com or 800-827-3500 ext. 330. Reprinted with permission from Raddon Financial Group.

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