Mercator Blog

A Requested Clarification of Regulation II Could Change Prepaid and Challenger Banks as We Know It
Date: January 27, 2021
Sarah Grotta
Director, Debit and Alternative Products Advisory Service

Within the crevices of the Federal Reserve Board website there are sometimes some fascinating documents detailing conversations industry leaders undertake with the Fed.  One such document appeared in December 2020, which, if acted upon could turn the business model for prepaid card program managers and challenger banks completely upside down.  

The Clearing House (TCH) met with members of the Federal Reserve Board to convey what they believe to be an unfair application of the small issuer exemption to the debit card interchange caps as applied under Regulation II, the outcome of the Durbin Amendment to the CARD Act.

Most prepaid debit cards in the U.S. are issued by smaller banks with less than $10 billion in assets. Most Banking-as-a-Service (BaaS) providers that supply fintech organizations with bank account functionality are likewise in the small bank category. This asset level allows the issuer and in turn the third-party organizations using and selling prepaid or banking accounts to earn the higher, market-set interchange rate for dual-message debit card transactions (formerly called signature debit), approximately 140 basis points of the transaction value.

Debit cards issued by banks with greater than $10 billion in assets will earn on average 54 basis points, or 61% less interchange revenue. Most of the third parties depend on interchange as a large revenue component.

The letter from TCH asserts that those banks that sponsor prepaid card programs are miscategorized and should only earn the regulated level of interchange.

What's in the Letter from TCH

In TCH's letter to the Fed, they are not asking for a change to Regulation II, but a clarification that would be administered though the FAQs.  There are two primary assertions.  First, TCH makes the argument that when considering the asset size of the prepaid bank issuer, both the assets of the bank and the assets of the third-party organization that is using the prepaid cards should be combined to determine if the small bank exclusion should be applied.  Here's how that is worded in the letter:

The Clearing House recommends that the Board issue a new FAQ or amend its official commentary to Section 5(a) of Regulation II (which describes the small issuer exemption) to establish that such exemption will not be available to an otherwise qualifying financial institution with respect to any program for which…..(iii) the combined assets of the issuer and the third party are equal to or greater than $10 Billion.  The Clearing House believes such an approach would be consistent with the fact finding/surveying done by the Board in contemplation of the rule that was published in 2011 in so much as the Board appears to have sought to understand the relationships between entities that establish issuing arrangements through that process.

As a theoretical example, if a small issuing bank were to partner with a firm like PayPal, then PayPal's assets of $51 billion would clearly put that bank beyond the $10 billion asset level.  Since a bank can exist either on the Federal Reserve Board's list of banks exempt from the interchange caps or those covered by the regulation, presumably this new designation as a large bank would apply to all card programs issued by that bank, not just those of the large third party that caused the jump in asset size.

This would mean that payroll card providers, incentive and rebate firms, gift card providers and other program managers with few assets would get caught up in the re-designation and also experience a significant drop in revenue.

It should be noted that programs issued for the government, such as Social Security or the recently issued cards for the Economic Impact Payments distribution will not be affected as cards issued for government purposes are exempt from the regulation entirely.


In a follow-up conversation with The Clearing House on February 2, it was made clear that the intent of the letter to the Federal Reserve is to bring only those third parties with greater than $10 billion in assets under the regulated interchange caps. Smaller program managers would continue to earn unregulated interchange. The financial institutions that support these programs would then need to separate their large clients from smaller program managers through a unique BIN in order for the applicable interchange rate to be applied. TCH supports the small bank exemption in Reg II. Let’s hope the Fed does too.


Secondly, the letter also goes to lengths to discuss those programs where cards are issued by a sponsoring bank for purposes of a third party, yet that third party does not deposit the card balances with the issuing bank. In this case the bank issuer holds the ultimate liability to the payments system to ensure payment settlement is met. If balances are not on deposit with the bank, the bank is taking a calculated risk that the third party will always have access to the funds and will forward them to satisfy transaction settlement as it occurs.

This business model is used most often by neo or challenger banks using prepaid cards to manage their customers' funds.  When a challenger bank customer completes a card purchase, the challenger bank will forward the funds to the issuer bank just in time, or shortly after settlement of that transaction as required by a card network.

Mercator Advisory Group will be publishing a report on the U.S neo/challenger bank market in the coming months that will illuminate the volume of deposits these fintechs have acquired.

TCH brings up this practice because this business model follows the model of decoupled debit - where the card and the deposit are "decoupled" in separate organizations.  Decoupled debit transactions always earn the lower regulated interchange under Regulation II.   TCH highlighted the following in its letter:

The official commentary to Section 2(f) of Regulation II already provides that debit cards issued by small issuers as part of a decoupled debit card program are categorically ineligible for the small issuer exemption.  Presently, the Board describes "decoupled debit cards" as "debit cards issued by an entity other than the financial institution holding the cardholder's account."  In a decoupled debit arrangement, transactions that are authorized by the card issuer settle against the cardholder's account held by an entity other than the issuer, generally via a subsequent ACH debit to that account.

If the Fed agrees that programs that are not funded at all or not fully funded are in fact decouple debit programs, then these programs would see their interchange income drop by over 60%.

There are always consequences.

Any action that alters the business model this significantly for a product or program will have consequences for the market.  If the Fed is in agreement with THC's first assertion and the assets of third-party program managers should be combined with those of the issuing bank for consideration of the application of debit interchange caps, then the ramification for the market includes:

  • Revenue will drop for nearly all non-government prepaid programs and BaaS relationships regardless of type as most issuers have a least one large client, or a combination of several clients with significant assets that would put them over the $10 billion market and in the regulated interchange category.
  • Those programs that are particularly dependent on interchange as opposed to fees or unclaimed balances will need to introduce new revenue channels.  This will be particularly difficult for challenger banks who count on interchange for nearly 80% of their revenue.  
  • There may be some banks that decide to enter the market and specialize in supporting third parties with low assets, or attract program managers away from banks established in the prepaid/ BaaS market that need to shed some clients to stay below $10 billion in assets.

If the Fed agrees to the second point of the assessment that accounts without balances at the issuer are indeed decoupled debit programs, then compliance may be a little easier and consequences not quite as dire:

  • The third party would need to fund its accounts at the issuer, which means that they cannot use those balances for other purposes such as funding their operations or investing them for the best return.

Why is TCH bringing this to the Fed's attention?

TCH is an interesting organization to be at the forefront of this issue.  They don't play a direct role in supporting prepaid programs.  TCH is, however, owned by a number of large financial institutions that do have an interest in prepaid and one or several of these banks could have chosen TCH as their proxy on this issue to preserve a level of anonymity.

These banks likely have the belief that fintechs are receiving an unfair advantage through higher interchange on prepaid or BaaS solutions and big banks could be competitive if only the playing field were more equitable.

This assessment puts the Fed in an awkward position.  If the regulator agrees with TCH and clarifies Regulation II as described in the letter, the Fed effectively decimates an industry that has created payment efficiencies, spurred innovation, and helped to serve underserved populations.  If the Fed does not clarify Regulation II, then this becomes exhibit A for big banks of how regulators and legislators are perpetuating a less-than-fair competitive environment with better revenue opportunities and a lighter regulatory application for some but not others.

Remember too that banks are already facing the outcome of a letter that Sen. Durbin sent to the Fed, which, if enacted, would require all banks to offer dual message transactions through their EFT (PIN) debit networks, lowering the volume they send through the global networks.  For more on this topic, members of Mercator can read Calling Out Winners and Losers if Regulation II is Redefined.

How Will This End?

With a new administration, it's hard to predict how the political winds will shift on an issue like this.  Many in Washington, D.C., would be loath to be associated with something that benefits big banks.  But if Regulation II is clarified as TCH has described, this also pulls in the reins on big fintech, no longer the darling of policy setters.  And by reducing interchange on a whole category of payments, small businesses will see lower swipe fees which is certainly politically popular.

One possible outcome is that the Fed agrees with the assessment around decoupled debit but not regarding the combination of assets.  This provides both camps on this issue with a "win" and makes no one happy.

This is a topic which Mercator will continue to watch as it unfolds.  We will publish an in-depth analysis of this topic and how it might impact each segment of prepaid in the coming weeks.