WASHINGTON, Oct 25 (Reuters) - The U.S. Federal Reserve is set to propose slashing the amount of fees banks can charge merchants for processing debit card transactions by nearly a third, setting up a pitched battle between the two industries.

The Fed proposal, due to be voted on by the board later Wednesday, would cut the current cap from 21 cents per transaction to 14.4 cents per transaction. The Fed said the reduction was in response to data received since the cap was first set in 2011, showing transaction processing costs had roughly halved.

The proposal would also slightly trim an added fee that banks can charge from 0.05% of the cost of the transaction to 0.04%. However, the Fed did propose expanding a supplemental fee banks can charge to cover fraud prevention services from 1 cent per transaction to 1.3 cents per transaction, citing a slight uptick in those costs over the years.

In practice, the proposed changes would result in, on average, a 17.7 cent fee on a $50 transaction, down from what would be a 24.5 cent fee today, according to Fed officials.

The Fed also proposed automatically adjusting the cap every two years in response to fresh data.

The sizable reduction in the fees, which generated $31.59 billion for lenders in 2021, according to Fed data, will set off an intense lobbying battle between the two industries, as well as a potential court challenge in the future.

Wednesday's proposal marks the first time the Fed has tried to adjust the cap since it was first established in 2011. The cap on so-called "swipe fees" was prescribed as part of the 2010 Dodd-Frank financial reform law, directing the Fed to set a limit that is "reasonable and proportional" to the actual costs of processing the transactions.

Retailers had complained to the Fed for years that the existing cap was set too high, according to Austen Jensen, a lobbyist with the Retail Industry Leaders Association, which represents Target and The Home Depot among other large retailers.

"It’s out of line, it needs to be adjusted," he said. "I feel confident we’re going to come out on a good spot on this."

Shares in credit card companies Visa and Mastercard were lower last week after the Fed announced the meeting to reconsider the cap.

In a letter to the Fed sent Friday, nine major bank trade groups said retailers don't pass on to consumers savings reaped from the 2011 cap and that claims they would pass on future savings "should be viewed with robust skepticism."

Analysts said that it is likely the Fed could face a legal challenge from either industry if it pursues new caps.

TD Cowen analyst Jaret Seiberg said in a research note the Fed "likely expects both the banks and the merchants to challenge any final...rule even if that final proposal simply ratifies the status quo." (Reporting by Pete Schroeder; editing by Michelle Price and Aurora Ellis)