Does the contingent liability to which an acquiring bank is subject in the course of the merchant acquirer business qualify as an off-balance sheet item according to Annex I CRR?
This question relates to the merchant services industry, whereby an authorised credit institution acts as a merchant acquirer, i.e. a bank which processes credit and debit card payments for merchants.
As part of this business the acquiring bank accepts card charge records for items purchased by a cardholder from a merchant, collects funds from the bank that issued the credit card to the consumer (issuing bank), and remits the funds to the merchant less fees. Acquirer banks also process credit card refunds made through the merchant’s distribution network and ‘chargebacks’ initiated by the cardholder through the cardholder’s card issuing bank.
In the course of this business the acquiring bank is responsible for all losses that the merchant introduces into the card associations’ networks which the merchant will not or cannot cover. This could arise, for example, where there is a disputed transaction due to non-delivery of goods or services, or due to fraud, or due to the bankruptcy of the merchant, in which cases the cardholder is entitled to chargeback such transactions.
Therefore, and despite certain contractual mitigants which may be in place, such as the right of the acquiring bank to delay any payment to the merchants and the right of set-off to the acquiring bank in respect of any liabilities owed by the merchant, the acquiring bank carries unsecured contingent financial liability for the value of all transactions processed by its merchants. The contingent liability is a result of the acquiring bank’s potential obligation to the issuing bank, should the issuing bank raise, for instance, a chargeback claim on the acquiring bank within the card association rules.
Card schemes have liability rules in place their members must comply with, in particular in the case of fraud, unauthorised transaction, or payment execution issues. These rules regulate liability and refund mechanisms often known as charge-back between the payer’s and the payee’s payment service provider.
Whether the risk of contingent liability to which an acquiring bank is exposed to in the course of the merchant acquirer business qualifies as an off-balance sheet item according to Annex 1 of Regulation EU) No 575/2013 (CRR) depends on how the relationship between the parties involved is structured. At least two cases can be distinguished:
(i) the acquiring bank is subject to charge back rules set up between acquiring and issuing banks and as such is responsible for meeting chargeback claims raised against the merchant by the card holder through the issuing bank including in case of the merchant bankruptcy, if the terms of the contract provide so.
(ii) the acquiring bank is only responsible for the execution and settlement of a payment transaction, i.e. that the payment itself is executed correctly and is not fraudulent. The responsibility of the acquiring bank does not extend to the execution and delivery of the goods and services themselves. If a payer was to ask for his/her money back due to him/her not being satisfied or the goods not having been delivered for instance, any such claims and any related open balances would have to be settled directly between the merchant, the issuing bank and the card holder.
In case (i), the acquiring bank is exposed to a contingent liability that classifies as an off-balance sheet item within the meaning of Annex 1 of the CRR. This off-balance sheet item exists as long as the card holder or the issuing bank has the right to raise a chargeback claim against the merchant.
Consistent with the approach applied in Q&A 2198, depending on the specific nature of the commitment made by the acquiring bank, and also having regard to any relevant card scheme rule/s and/or merchant agreement/s, since the contingent liability as described may not correspond directly to any of the items explicitly described in Annex 1, this should either be treated according to Annex 1, item 1(k), or item 2(b)(iv), or item 3(b)(ii), or item 4(c), i.e. ‘Other items carrying [full, medium, medium/low, low risk, as appropriate] and', where applicable, 'as communicated to EBA'.
However, with specific regard to cases where the contingent liability covers merchant bankruptcy such that in the case of a chargeback where the merchant defaults on its obligations to refund the issuing bank and the acquiring bank has explicitly committed to fully cover this loss, this would necessarily be a full risk item.
Where the relation between the parties involved is instead structured as described in (ii) above, the acquiring bank is not exposed to the credit risk of the merchant, as it is only responsible for the settlement of the card transactions. Therefore, in this case there is no off-balance sheet item according to Annex 1 of the CRR.
Update 26.03.2021: This Q&A has been reviewed in the light of the changes introduced to Regulation (EU) No 575/2013 (CRR) and continues to be relevant.