* Fed proposes 12-cent cap on debit interchange fees
* Wants more comment on fraud-prevention costs
* Proposal is called for in Dodd-Frank reform law
* Promotes competition among card networks
* News sends Visa and MasterCard shares tumbling (Rewrites with further details, comment; updates shares)
By Dave Clarke and Maria Aspan
WASHINGTON/NEW YORK, Dec 16 (Reuters) - U.S. banks face deep cuts in the debit card fees they charge retailers under a Federal Reserve proposal that also exposes card networks Visa (V.N) and MasterCard (MA.N) to more competition.
Shares of Visa closed down 12.7 percent and MasterCard fell 10.3 percent on Thursday as investors feared the industry could lose billions of dollars in revenue.
The proposal would generally limit so-called debit "interchange" fees at 12 cents per transaction. The average interchange fee for all debit transactions was 44 cents per transaction in 2009, the Fed said.
The banking regulator also sought comment on requiring debit cards to offer multiple networks -- allowing the same debit card to be processed over either Visa, MasterCard, or rival payment networks like NYCE, a unit of Fidelity National Information Services Inc (FIS.N).
The proposal is a win for retailers who have long lobbied for fee cuts but it also puts heavy pressure on Visa and MasterCard, the largest card networks.
One payments industry source had a succinct email response to an inquiry about the Fed proposal: "Ouch."
Shares in major card-issuing banks, such as Bank of America (BAC.N), were up or flat in line with the broader market.
Visa had no immediate comment. MasterCard General Counsel Noah Hanft called the proposal "misguided and anti-competitive" and "harmful to consumers."
The sweeping Dodd-Frank financial industry reforms signed into law in July called for new curbs on debit card fees. [ID:nN14289632]
The Fed is required by the law to put out a final rule on the fees by April 21 and it would become effective in July.
The Fed called for public comment by Feb. 22.
"If you look at the 12-cent cap, that's certainly much more of a cut than people were anticipating," said Michael Nix, a portfolio manager at Greenwood Capital Associates.
Nix's firm owns Bank of America and Visa shares. He said he had thought about selling his Visa stake -- "and now I wish I had."
Sanford C. Bernstein senior analyst Rod Bourgeois estimated in a research note that the Fed proposal "implies a 71 to 74 percent cut in debit interchange. This compares to a Street expectation of around a 50 percent cut."
Banks charge retailers a fee when a customer uses a debit card. Totaling about $20 billion a year, the fees are collected by transaction processors like Visa and MasterCard, which in turn charge the banks separate network fees for that service.
The financial industry still has an opportunity to shape the proposal, which includes alternatives and asks for comments on how to define fraud prevention costs.
Banks and transaction processors want regulators to broadly define those costs, and allow them to recover such costs through the interchange fees.
"I think we have to be particularly open minded to comments," Fed Governor Daniel Tarullo told a public meeting of the banking regulator on the issue.
Currently a debit card can only be processed over Visa or MasterCard for signature purchases.
The competition element of the proposal could be especially damaging to Visa, which dominates the U.S. debit market, and could potentially offer MasterCard an opportunity to win more debit processing business, Bourgeois wrote.
The Fed proposed two variations on interchange fee limits.
Under one, banks would compute the average variable cost of authorizing, clearing and settling a transaction. This fee would be capped at 12 cents per transaction. If a bank decides it does not want to compute its cost it can set its fee at 7 cents per transaction -- a "safe harbor." The second proposal is simply for a 12-cent cap.
Community banks were unhappy, arguing the Fed proposal would hurt their profits, despite a specific exemption under Dodd-Frank for institutions with under $10 billion in assets.
Small banks have said there is no way to enforce this provision and that merchants are likely to pay the lower interchange fee established by the Fed rule.
The Fed rule contains no enforcement provision and at the Fed board meeting, staff said there would be nothing to prevent merchants from enforcing one fee on all banks, much to the chagrin of community bankers.
"The proposal turns the debit card payment system on its head," said Viveca Ware, a senior vice president at the Independent Community Bankers of America. (Reporting by Dave Clarke and Maria Aspan in New York; Writing by Kevin Drawbaugh; editing by Gerald E. McCormick, John Wallace and Tim Dobbyn)