Understanding the Role of Interchange Fees

Neo banks, or digital-first banks, have revolutionised banking by offering seamless, tech-driven financial services. Unlike traditional banks, neo banks operate without physical branches, allowing them to keep costs low. But how do they make money? One of the key revenue streams is interchange fees. Here, we’ll dive into what interchange is and explore the factors that influence interchange rates, shedding light on how neo banks generate income.

What is Interchange?

Interchange fees are charges that merchants pay every time a consumer swipes a card to make a purchase. These fees are distributed among the various parties involved in processing the transaction:

1. Issuing Bank: The bank that issued the card used for the transaction.
2. Acquiring Bank: The bank that processes payments on behalf of the merchant.
3. Card Network: Networks like Visa, Mastercard, or American Express that facilitate the transaction.
4. Payment Processor: Companies that provide the technology for payment transactions.

For example, if a consumer swipes a card issued by a neo bank, $1.70 from the interchange fee might go to the issuing bank and card network, while $0.50 is allocated to the acquiring bank.

How Neo Banks Benefit from Interchange

Neo banks typically act as the issuing bank in these transactions. They earn a portion of the interchange fee, which becomes a significant revenue source. This fee is especially lucrative when paired with high transaction volumes, which neo banks encourage through features like rewards programs, user-friendly apps, and partnerships with popular card networks.

Factors That Impact Interchange Rates

Not all interchange fees are created equal. Several factors influence the rates and, consequently, the revenue neo banks earn:

1. Credit vs. Debit

Credit cards usually carry higher interchange fees compared to debit cards. Neo banks often incentivise customers to use credit cards by offering rewards or cashback, boosting their interchange revenue.

2. Rewards Programs

Rewards programs—like cashback or points for travel—are financed through higher interchange fees. These programs attract consumers, increasing card usage and interchange revenue for neo banks.

3. Online vs. Offline Transactions

Online transactions tend to have higher interchange rates than in-person transactions due to increased fraud risk and additional security measures required.

4. Consumer vs. Commercial Cards

Commercial cards associated with business or corporate accounts carry higher interchange rates than consumer cards. Neo banks catering to business customers can capitalise on this difference.

5. Merchant Category Code (MCC)

The type of merchant accepting the card affects interchange rates. For example:

• Supermarkets may have lower rates.
• Retail stores and fuel stations often incur higher rates.

6. The Card Network

Different networks charge different interchange rates:

• Visa and Mastercard typically have lower rates.
• American Express often charges higher rates, which can lead to increased revenue for the issuing bank.

7. Network Partner Programs

Visa and Mastercard offer partner programs, such as the Visa Partner Program (VPP) and Mastercard Partner Program (MPP). These programs allow specific retailers to negotiate lower interchange rates, which can indirectly impact neo bank revenue when they issue cards for these networks.

8. Size of the Issuing Bank

In the United States, the Durbin Amendment caps interchange rates on consumer debit transactions for large banks. Smaller banks are exempt, allowing them to earn higher interchange fees. Neo banks often partner with smaller banks to benefit from this exemption.

Diversification Beyond Interchange

While interchange fees form a core revenue stream, neo banks also diversify their income sources through:

• Subscription Fees: Premium accounts with additional features.
• Lending: Personal loans, credit cards, and Buy Now, Pay Later (BNPL) services.
• Wealth Management: Investment products and robo-advisory services.
• Partnerships: Collaborations with fintechs and other businesses for embedded finance solutions.

The Future of Neo Bank Revenue

As neo banks continue to scale, their reliance on interchange fees may decrease as they diversify into lending, subscriptions, and other financial services. However, interchange will remain a cornerstone of their business model due to the steady revenue it provides.

By leveraging technology, optimising partnerships, and tapping into high-yield interchange opportunities, neo banks are poised to remain competitive in the ever-evolving financial landscape. This innovative approach ensures that they not only survive but thrive in the digital-first era of banking.

At Digital One Agency, we specialise in creating bespoke fintech solutions that enable neo banks and financial institutions to optimise their revenue streams. With over 25 years of development experience, we can help you build robust systems tailored to your business needs. Contact us at contact@digitaloneagency.com.au or call us at +61 2 9057 9079 to learn more about our services.