Debit cards are hidden financial infrastructure

Patrick McKenzie (patio11)

Credit cards are a bundle of a payments instrument and loan origination. You might think debit cards must be strictly less interesting, given that they lack the loan origination. They’re actually a core piece of financial infrastructure, accidentally upgraded checking accounts, and drive (and fund) much fintech innovation.

Debit cards made retail banking a better business

Much of financial services concerns stocks and flows; money sitting mostly idle or money moving between places. Financial service firms can charge for either of these or both, but typically one predominates.

Prior to the introduction of debit cards, core deposit accounts for retail users were a boring business to be in. (Banks historically consider consumers and small businesses to have strikingly similar banking needs and, largely for organizational reasons, group them together. We’ll call them “retail” users for simplicity; different banks call them “core banking”, “community banking”, and similar internally or in their financial statements.)

In the United States and much of the world, payments are free or near-free for retail bank customers. The defining feature of U.S. deposit accounts, check processing, both lends them their name (“checking accounts”), contributes billions of dollars of operational cost and credit risk, and is assumed to be free for both sides of the check transaction. This was historically subsidized by net interest earned on one’s balances and by using the core deposit relationship, and the frequent stops by the bank branch it used to entail, to sell loan products which had a healthier margin profile.

An interesting wrinkle about net interest is that most customers don’t contribute much. In much of the U.S., median checking account balances at account creation are only around $3,000. On a portfolio level, they increase slowly over time as customers' incomes rise slowly over the course of their career and as they save money.

At a 4% net interest margin, this account would only contribute about $120 in margin during its first year. In the U.S., the industry generally estimates approximately $350 a year in costs to maintain a checking account, of which approximately $120 is direct marginal cost (as opposed to e.g. a pro-rated portion of the cost for the branch footprint).

So most checking accounts (and particularly, most checking accounts where the customer had no other products from the bank) were negative contribution margin. That sounds better in an annual report than "We lose money on most customers even when everyone does everything right."

They were subsidized by banks and, indirectly, by customers of banks with larger balances, who were mostly unwittingly paying a higher spread between their own deposits and their loan pricing. This was a considered policy choice, because (as previously covered) the government prefers almost all members of society to be banked, but it was not an easy policy to implement around the edges. In particular, neighborhoods which had low concentrations of retirees and small business owners were difficult to service profitably on the branch model. Regulators and legislators attempted to put a thumb on this scale for decades, with mixed success.

Enter debit cards, which like many technologies were available (1960s) before being common (1980s) and then becoming ubiquitous (1990s). Debit cards  fundamentally transformed the economics of retail banking.

Consider again the median bank user, who might have a pre-tax income of around $60,000, post-tax post-transfers cashflow of $3.5k a month, and rent of approximately $1,000. (These numbers likely sound low to many readers; remember that the median American is not a professional employee in a coastal city.)

This user might very well have somewhere on the order of $2,000 of debit card transactions a month. This implies about $300 a year in interchange revenue, substantially more than their contribution from net interest.

Debit cards were a major structural factor in the retail banking boom of the 1990s, because neighborhoods which were once marginal prospects for new branches were suddenly both a) directly margin contributive immediately while b) having several embedded options on neighborhood economic growth, aging of the customer base, and cross-sells within the customer base. Neighborhoods that had handily merited a bank branch for the same reason now saw increased competition, from multiple banks first and eventually from multiple branches per bank, as each bank worried that a competitor could steal their debit cards by being one block more convenient.

This isn’t just an American story. Here in Japan, the persistently low interest rate environment for the last 30 years has made retail banking a very bad business to be in. However, over the last 15 or so years, the Japanese financial industry and government have made a concerted push to move the nation from being cash-based to using electronic payments, which for most typical consumer purchases means credit cards. The government’s current target is 40% of the payments mix, about double the current amount, which would put it on parity with the present state of play in the U.S. (and behind Asian peer nations, at around 50%).

Debit cards as an infrastructure upgrade

In addition to revolutionizing the economics of retail banking, in the U.S., debit cards quietly (and mostly accidentally) introduced instant business-to-consumer payments.

Many European readers are amazed that I keep harping on this, but “money moves much slower than data” has been a core feature of the U.S. experience for my entire life. The reasons behind that could fill volumes, but for now please just accept that we run the largest economy in the world on top of financial infrastructure that truly does lack a core primitive you’d expect it to have.

Anyhow, a bundled feature of credit cards and debit cards alike is that businesses can refund transactions. This is broadly considered a boring implementation deal. And they can even over-refund transactions in some circumstances. This was largely planned, to the extent it was planned, as an operational convenience. A customer might buy $150 of dresses in two transactions, return them to the store, and receive a single $150 refund rather than having the clerk hunt down both original transaction IDs to refund.

Eventually, someone realized that over-refunds plus debit cards accidentally create a novel payments network. You could just capture a debit card and then refund money never actually spent on it to transfer the customer money. That money would arrive in their bank account substantially instantly, rather than in the 3-5 business days that was more typical in the U.S. until recently. This required no negotiation with their bank, travelled over nearly universally accepted existing infrastructure, and involved no mutli-party stakeholder negotiation over whether a migration would disadvantage any economically significant part of the financial ecosystem.

This feature quietly lurked in the financial industry for many years but only became widely adopted in the last decade, first by the gig economy and then by wallet apps.

Typically, the apps offer their users a choice: payouts at the speed of banking, for free, or payouts at the speed of the Internet, for a small convenience fee. Cash App charges 1.5% with a minimum of a quarter. Lyft charges a flat fee of 50 cents.

This is an extremely high margin service and it is very, very, very popular with users. Many report that it transforms the nature of their interaction with the underlying application; delivery driving for casual drivers becomes something that you can burst up to fill an immediate cash need or mentally allocate against a particular desired expenditure (e.g. “Drive for 3 hours to afford a night out starting immediately after you log off.”)

The actual physical implementation of this once used niche financial players but these days is offered directly from Visa and Mastercard. Stripe offers it as a product called Instant Payouts.

Interestingly, pricing instant payouts serves an important packaging goal for fintech applications: the actual thing that the user wants isn’t money in their bank account faster. It is to be able to meet an obligation at a known time in the immediate future. Charging a convenience fee for instant payouts allows fintechs, and businesses with embedded financial infrastructure like gig economy platforms, to position their own debit cards as a free alternative with the same instantaneous funds availability.

This allows the fintech to shift the cost of instant payments from their own users to the businesses their users transact with. In particular, in the U.S. at present, they’ll almost certainly do this by having a debit card issued by a Durbin exempt financial institution.

Durbin-exempt interchange

We covered this briefly in the issue on community banking, but debit card interchange in the U.S. is presently capped to 21 cents plus 0.05% of the transaction. This is much, much lower than credit card interchange.

This was passed as part of the sweeping Dodd-Frank legislation in the wake of the financial crisis. If you imagine society as being in a perpetual dialogue with the financial sector, you can conceptualize this as a demand: in return for partially paying for your bailouts, commercial users require you to not charge us nearly as much for payment services. Find another way to subsidize your retail bank users; it’s not our problem.

Community banks had this to say about that: we didn’t cause the global financial crisis. We weren’t there on Wall Street creating exotic derivatives on asset backed securities. (Community banks might, ahem, hope that anyone who understands the mortgage supply chain stayed had too many things to worry about to protest this point.) We remade our retail franchises around the expectation of debit card interchange. If you cap the price on it, you’ll kill our institutions, cause millions of Americans to lose access to branch banking, and further roil the commercial real estate market, which we fund in most of the nation.

Senator Dick Durbin heard arguments like this, substantially agreed with them, and proposed an amendment to Dodd-Frank exempting banks with less than $10 billion in deposits from the interchange cap. It passed, and the fintech industry (which barely existed at the time) accidentally inherited a business model.

The fintech industry calls institutions under that cap Durbin-exempt issuers. Most of them continue issuing debit cards to their local communities, as they’ve done for decades. A handful of them partner with other firms to provide debit cards (and other banking services) to those firms’ customers.

This was an unintended structural alliance, but is extremely favorable for businesses engaging in it. Fintech companies offer relatively deep integrations with regulated financial services without themselves having to become banks, by piggy-backing on underlying banks’ capabilities to offer those services. The banks handle the compliance, custody, risk management, and a portion of the customer service, as they always have, but the fintechs provide a scaled national go-to-market strategy that no community bank could independently develop.

The most visible beneficiary of this has been the neobanks, which in the U.S. at least are almost invariably software companies that have a mobile app which integrates tightly with a debit card provided by a partner bank. That is (by far!) the easiest pathway to launch a banking product in the United States; it takes literally years, tens of millions of dollars, and substantial execution risk off of go-to-market. Most neobanks will attempt to figure out a scalable approach to attracting and retaining customers then try to increase contribution margin through other products. (It is an interesting open question whether neobanks in the U.S. will ever outgrow their banking partners, either for operational reasons or because society demands it of them.)

Many infrastructure providers, Stripe included, further abstract financial services (like debit card issuing) into suites which they offer to platforms building up on them. This “embedded fintech” lets companies whose core competence is software development for a particular vertical industry deeply integrate financial services into their core platform without actually providing it themselves.

Innovation is happening apace in this space, but as of today, the main monetization engine for this sort of relationship is the Durbin-exempt interchange on debit cards. The software platform, fintech platform, and bank split on the order of a hundred and change basis points (1.X%) of each transaction of their customers.

The value proposition for customers is an interesting one. Its a faster way to get access to one’s money. But the money is also… better? Because it is enhanced by the software provided by the platform, which can mirror a ledger of it (like any financial institution could) but use intimate knowledge of the customer’s business to make their software offering categorically better given that it is aware of transaction-level data about how money flows.

This lets platforms do things like e.g. automated tax reporting, bookkeeping, business analytics, etc, on top of their core services, without needing to directly charge their own users for this. The payments revenue is (from the perspective of the platform) extremely high margin.

SaaS companies offering "money, but better" thus act as an acquisition channel for relatively small banks which would otherwise have their own software offerings comfortably crushed by the largest banks in the world, which in the past few years have actually started to introduce very good mobile applications. Those banks have not, however, started innovating with respect to particular business or customer verticals; their retail offerings are (sometimes painfully) one-size-fits-all.

These services tend to make sticky products even stickier. Businesses can churn off a SaaS product, but once the SaaS product is intimately integrated into the flow of operations of their business, churn rates decrease markedly. It is difficult to get more intimately integrated with a business than to be directly in their cash flow. Since SaaS companies' enterprise values essentially move inversely with churn rates this is extremely powerful for them, even on top of the direct revenue contribution.

And thus a measure intended to rap Wall Street’s knuckles for the financial crisis has inadvertently caused rapid innovation in the main financial surfaces that many consumers and, particularly, small businesses interact with.

Infrastructure: it’s a fascinating world.

Further reading

Many readers have asked where I’d suggest starting to get a better handle on these topics. Payment Systems in the U.S. is my go-to recommendation for a quick survey, although I don’t love the book. The American Banker magazine has many interesting factoids about e.g. the economics of checking accounts in its back archives.

The Federal Reserve system (and its counterpart in other nations) publish very detailed reports on these subjects, and while their discoverability can frequently be poor the comprehensiveness is wonderful.

Finally, if you have dozens of hours to invest in the topic, getting familiar with the quarterly and annual reports of a small number of banks will, over time, really help to develop intuitions about both banking and the payments industry.

If you’ve not previously worked professionally on this, try First Republic’s reports; they’re large enough to have good production value on their reports but they have a very simple business to understand relative to e.g. the largest banks in the world. Wintrust and Silvergate are also good for similar reasons. After you feel like you largely understand what a typical bank’s reports look like, try Green Dot Bank or Evolve Bank and Trust to see how interaction with fintechs changes the equation.

If you find this sort of thing interesting, Stripe is hiring aggressively. As always, my views on these subjects are my own, but I like to think that I've learned a bit on this industry in my five years here.

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