One of our bank clients recently asked us to review their debit card fees vs. interchange revenue. The bank’s CEO has some creative ideas around a cards-based revenue sharing program for his bank’s customers to boost loyalty and encourage deposit account growth. He also wanted to dig into the details around how the interchange revenue worked and determine if he was on the right interchange network, or whether he should be shopping for a new one.
Some interesting results came out of our analysis that are likely universal truths for most community financial institutions (aka FI’s-banks or credit unions), and which drive quite a bit of non-interest income for the FI.
Understanding the Lingo:
If you are less familiar with the term interchange revenue, it is the FI’s share of the fees generated when an FI customer makes a purchase.
Here is how that works:
A customer goes to McDonalds, buys a Big Mac with the card issued by the FI. McDonalds gets charged a fee which is split three ways, with a portion of that fee coming back to the FI that issued the debit card. The FI is also charged an expense each time a customer uses their PIN or signs the signature pad device at the retailer. But generally, the interchange revenue for FI’s of a certain size exceeds their expense, so card transactions are usually considered a non-interest source of revenue for the FI.
Maximize Revenue and Minimize Expense
Since this is a source of revenue for the bank, every CEO should be asking how you can maximize revenue or minimize the expense of your customer’s debit transactions to increase the net fees. So, here are a couple of lessons learned from our recent analysis:
1. Count Your Interchange Networks
Most banks have signed contracts with multiple networks. However, the revenue of all networks generally is consolidated in a single report, and so over time many of our customers do not even know how many networks they are using beyond their primary-Visa or Mastercard.
Think of it this way, your customer has bought that Big Mac and now McDonalds wants to route the traffic to the least expensive channel for them. So, McDonald’s algorithm looks at the Visa charge and compares it to the alternative network(s) charges, and routes that transaction to the least expensive option for McDonalds.
Visa is large and a good negotiator, so they are likely an FI’s best friend; both collecting the highest revenue from the retailer and passing along the highest revenue to the FI. McDonalds is also a good negotiator and so likely got decent rates from Visa, but better rates from the smaller alternative providers. So wherever possible, McDonalds will route the transaction to the cheaper alternative providers. An FI is required by law to have at least two networks available to the retailer.
If the FI has multiple alternatives open to the retailer, then they are giving McDonald’s more opportunities to find a cheaper place to go with the transaction. Cheaper for McDonalds generally means less revenue for the FI. Since your alternative network values as many transactions as they can get, they pay the FI a better rate if they are the sole alternative network.
Lesson learned: FIs can strategically position themselves for the highest revenue gains by contracting with only two networks, rather than three or more.
2. Follow the Money – Analyze Your Revenue Reports
For this client, we had the opportunity to work with a provider who both charged the bank for the debit transactions and paid out the interchange revenue for the bank’s second network.
It took 60 hours to gather the data from the vendor’s various reports and compile it into something useful for the client. So not a real significant time investment, but even with a single vendor handling both sides of the transaction (revenue and expense), it was very difficult to define net revenue.
The client receives approximately $50K per month in interchange revenue but couldn’t interpret the revenue-side reports enough to determine how much they were making per transaction. The revenue reports had to be forced into a format which could be extracted and analyzed to find the per transaction number. This exercise alone took quite a bit of effort.
The vendor expense side of the transaction is fairly easy to understand but the revenue side takes a bit of experience and analysis to wade through. At one point we were wondering if the vendor was hiding the detail to keep the bank from learning too much about how they were getting paid, but in the end we realized that even the vendor making the payments had very few experts that understood how each side of the equation worked. If it is too complicated for your vendor representative or their boss to understand, you may need to spend some time researching it to really understand it.
Lesson Learned: Matching up what you pay for a debit transaction and what you receive in interchange revenue from the same transaction is difficult to interpret.
3. Don’t Forget the Expense Side of the Equation
The net revenue for any FI is the difference between the revenue they bring in and the expenses that they pay out. Every CEO should be focused on increasing the gap between those two numbers.
Our client was doing a couple things right. They used only one alternative network (not two or more) and the interchange fees that network was providing were in line with their peers.
Where they were losing ground is that the fee side of the equation was misaligned. They didn’t realize that they were paying higher-than-peer expenses for each debit card transaction, causing an unnecessary drop in income. We were able to realign their debit fees, causing an immediate improvement in their net revenue.
Lesson Learned: Reducing debit expenses is as good as increasing interchange revenue when it comes to your FI’s bottom line – and you need to start by understanding how you compare to your peers.
Looking for more real-world examples? Check out this related article: Lessons Learned From a $130 Million Core Contract Renewal
Beyond the Lesson: Four Universal Truths About Net Interchange Rates
It is very likely that your FI will see these “universal truths” our client experienced when it comes to your own interchange revenue:
- A transaction where the customer signed for a purchase pays more to your FI than the same transaction for a customer who used a PIN at the register.
- A transaction where the customer signed for a purchase also generally costs more to your FI than the same transaction for a customer who used a PIN at the register. However, the additional revenue generally exceeds the additional expense, making a signature transaction still preferable – and more profitable – to the FI.
- If your customers shop in areas with many large retailers, you likely make less in interchange fees than an FI who has fewer large retailers in their territory. Simply put, large retailers are more knowledgeable and have more negotiating power with the interchange networks than their smaller counterparts. The result is that you get less revenue on that Big Mac than if your customer had opted to eat at the local sandwich shop down the street.
- Your expense agreement for debit transactions may very likely be on a different contract, with different termination dates, than your interchange revenue agreements with your network. This makes it more difficult for an FI to optimize revenue.
So, hopefully you just became a bit more educated on interchange revenue and expenses.
If you find yourself in need, Remedy has experts in this area that can analyze your revenue and expenses and develop a strategy to improve the spread between the two for your debit transactions.