The year 2020 has caused a significant shift in the way Americans view everyday activities due to COVID-19. Many storefronts have implemented card only policies to slow the spread of the virus. However, the trend of using cards over cash has been tilting more towards cards for the last few years. According to the 2019 Diary of Consumer Payment Choice study conducted by the Federal Reserve, consumers have been using cash on a less frequent basis. In 2018, consumers used cash in 26 percent of transactions, down from 30 percent in 2017 (Exhibit 1). This trend presents an opportunity to consider turning a potential cost to institutions into a profit driver by earning interchange income. Reimagining your core checking product to require a minimum number of transactions or other usage-driven incentives may aid in accomplishing this. The question to answer is which strategy encourages more interchange income? Are consumers more incentivized by a higher dividend rate or rewards points? Aligning strategies with the wants and needs of your consumer base will drive higher interchange income. In a low rate environment (such as the one we are currently experiencing), this can generate income from a portion of the balance sheet that would otherwise be an expense. For institutions greater than $10 billion in assets, the impact of such a focus would be muted due to restrictions from the Dodd-Frank Act. However, most community financial institutions do not exceed that threshold.

Current Rates

In the first half of 2020, lowering deposit rates was a strategy to protect earnings after the sharp decrease in market rates and a flood of new deposits. However, most institutions are beginning to bump against the floor for deposit rates as the current credit union national average checking rate is 0.14% (as of 11/5/2020). This trend, combined with low yields and loan demand, is beginning to cause margin compression. To ease pressures on shrinking interest income, institutions often turn to non-interest income. In 2018, average interchange income for all transactions (covered and exempt) equated to around 0.78% of the transaction amount with the average transaction amount being $38.98. While $0.31 per transaction may not be enticing individually, it can add up with a strategy to encourage volume. Encouraging interchange income can turn dividend expenses into net positive income as shown in Exhibit 2.  

However, the other income earned is contingent on the member viewing an institution’s card as their main spending tool. While the decline in cash usage favors this, a major competitor is the use of cards from other institutions. Credit card rewards have become increasingly popular as consumers are able to earn rewards that can be used towards vacations, products, or cash back. If a consumer travels often they will be more incentivized to find a card with rewards that meet their needs. A card that offers more rewards towards travel will make it top of wallet for that consumer. However, another consumer could value earning a higher savings rate. Research on members’ preferences will help institutions roll out programs that encourage the most interchange income. Due to the popularity of reward programs on credit cards, institutions must incentivize members to use their debit card in addition to their credit card.

Potential Downsides

As with most strategies, there are potential risks associated with this strategy. First, it is important to note that the figures used in examples are only considering dividend expense and interchange income. Operational expenses are not included which can sway overall profitability. Another variable that needs to be considered is the average purchase size. In 2018, interchange income equated to around 0.78% of the transaction amount. There is the chance that members gather swipes through smaller transactions which would reduce the amount of interchange income realized. If a large percentage of members make smaller purchases it can lower the overall profitability of the strategy. A work around this is to require minimum transaction amounts to qualify. Lastly, any new regulations on interchange income could cap the amount of interchange income that can be earned. The Durbin amendment to the 2010 Dodd-Frank Act limited the amount of interchange income that can be earned. With the economic uncertainty it will be worth watching to see if there are any new regulations suggested to limit the interchange rate that can be charged to merchants.

Balance Sheet Strategy

Creating a tiered checking account that heavily compensates based on number of swipes may accomplish such a goal. Most tiered based checking accounts are segregated by balance to earn a higher rate. This is generally used to drive stability and create a more cost-effective model regarding servicing. However, for the purposes of earning interchange income, a tiered swipe checking product could be a viable solution. While compensating debit card users for swipes is not a new strategy, the current environment may create an opportunity to revisit the structure of all checking accounts even those that have some form of compensation for card usage. An example of how this may look is outlined in Exhibit 3.

In the example above, there are three tiers to the checking account each offering a different dividend rate. Tier 1 is defined as less than 14 swipes, tier 2 is 15 – 19 swipes, and tier 3 is 20 swipes and more. The dividend rates earned at each tier in the example are 0.10%, 0.25%, and 0.50%, respectively. Depending on the institution and member base, these dividend tiers may need to be more aggressive. This can be tweaked depending on intent of the program. To better illustrate this, a table outlining the number of swipes needed to breakeven at different levels of dividend rates is included in Exhibit 4.

The tiered approach serves as a reward to incentivize members to use their debit card over other credit cards or cash. ALM First acknowledges that liquidity is not a concern for most institutions, but this strategy can enhance an existing product. By placing swipe requirements, a net positive income is ensured by the institution between the dividend expense and interchange income. In addition, it gives members a reason to view an institution’s card as top of wallet which can promote more wallet share for other needs.

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