The Durbin Amendment And the Future of Interchange

The effort to repeal the Durbin debit regulations ignores deeper issues in the U.S payments industry, including the problems created by a flawed pricing system.

U.S. Rep. Randy Neugebauer, R-Texas, recently introduced H.R. 5465, a bill that would repeal the Durbin Amendment. This bill comes on the heels of many articles published by a number of payments-industry experts blaming “Washington mandarins” and “merchant lobbyists” for all the damage Durbin has allegedly brought upon consumers and the banking industry while calling for government to butt out of the payments system.

When introducing the bill, Rep. Neugebauer stated: “What the Durbin Amendment did … was artificially shift over $30 billion in revenue from one industry to another,” adding “… the Durbin Amendment was nothing more than a government action to manipulate the marketplace.”

Readers will recall that the Durbin Amendment, which is part of the 2010 Dodd-Frank Act, capped debit card interchange for issuers with at least $10 billion in assets and also required that all banks, regardless of size, issue debit cards that can be processed on at least two unrelated networks.

There is always another side to every story. Let’s look at the facts.

With the exception of Durbin, government’s involvement in the structure and cost of U.S. payments, by either the legislative or executive branches, is the least of any industrialized country in the world.

Other countries’ regulators take a more proactive approach to managing the pricing and stability of their payment systems. For example, Norwegian banks, with the full support of the Norwegian central bank, introduced higher fees on paper checks in the 1980s, and on ATM withdrawals last decade, to move consumers away from checks and cash to electronic payment instruments.

In Australia, the Reserve Bank cut interchange rates by nearly 50% in 2003. Many other countries around the world have also regulated or capped interchange.

Here in the U.S., other than Durbin, no government agency has shown any appetite to regulate payment fees. The organization with the clearest jurisdiction to do so, the Federal Reserve, has remained aloof, and appears indifferent to the issues regarding the cost of payments.

‘Feeling Mugged’

What has this hands-off approach delivered? For starters, the U.S. has one of the most inefficient payment systems in the world. Our bank transfer and clearing system is bloated with float and is one of the most expensive systems in the world in terms of social cost.

The cards environment is dominated by a duopoly that enforces one of the most expensive interchange and fee schedules in the world. Notwithstanding this dominance and high cost, the U.S. cards environment remains behind that of many other countries, as illustrated by the fact that the U.S. was one of the last industrialized countries to introduce EMV chip cards.

Clayton Christensen posited in his landmark book, Innovator’s Dilemma, that incumbents generally fail to innovate so they can protect their existing market share. The U.S. payments business is no exception. The cards duopoly and the largest banks have not led the market in delivering innovative products and services, and fight any innovation that would challenge their market dominance. Thus, Durbin has had little, if any, effect on issuer innovation or efficiency, or lack thereof.

On the other hand, consumers indeed got a bad deal from Durbin.

As any undergraduate economics student could have predicted, most merchants did not pass on their debit-interchange savings to consumers. First of all, depending on the type of merchant, the number of Durbin-qualified transactions as a percentage of transactions on all cards, including credit, non-regulated debit, and other non-Visa/MasterCard cards, was small, so the overall effect on prices was minor.

Second, economic theory tells us that when all players in a market receive an equal reduction in cost, and when pricing transparency is high (that is, you can see what your competitor is charging) and demand price elasticity is also high (that is, consumers will buy from your competitor given a small price difference), the rational behavior for an individual merchant is to retain its savings until the competitor reduces prices so the reductions can be matched if necessary.

If the competition does not lower its prices (also rational behavior on the competitor’s part), then all merchants retain the benefit from the interchange reduction.

So, from that perspective, Rep. Neugebauer is correct. Durbin redistributed fees that consumers pay from issuers to merchants. Had it ended there, it would have been a zero-sum game. However, many financial institutions, feeling mugged, chose to assess consumer fees, resulting in increased cost and service reductions.

Therefore, to blame only merchants for the increased societal and consumer cost to process the same payment transaction is disingenuous at best.

However, it is hard to blame banks for their overreaction. Durbin happened relatively fast, and banks, which were in the middle of a deep financial crisis, had to find alternative revenue sources quickly. So an argument could be made that this overreaction was a byproduct of Durbin.

Finding Equilibrium

A better argument, however, is that these overreactions happen any time infrastructure changes and key costs are determined by lawsuits or one-sided legislative action in the absence of a coherent long-term payments policy.

Yet, sometimes regulatory intervention is good. Had it not been for regulators setting mileage, pollution, and safety standards, we probably would still be driving gas guzzlers emitting lots of pollution and without safety belts and airbags.

Surely, these improvements added to the price that consumers paid for each car, but they lowered the overall societal cost of gas prices, balance-of-trade deficits, respiratory diseases, and accidental injuries and deaths.

Similarly, Durbin created an incentive to regulated banks to process debit transactions more efficiently. According to the bi-annual Fed Interchange Fee Revenue Study published in 2014 (for the year 2013), most high- and mid-volume issuers have lowered their authorization, clearing, and settlement costs for debit transactions to a level below what they earn in interchange revenue (4 cents per transaction for large issuers and 12 cents for mid-size issuers, excluding issuer fraud losses), which is lower than the approximately 22 cents that regulated banks receive in interchange.

So, regulated banks appear to be covering their costs and making money from interchange. Further, despite early concerns, “interchange revenue … continued rising for small banks” according to a recent study by the Federal Reserve Bank of Philadelphia.

Consumers also seem to be more aware of, and comfortable with, so-called swipe fees. In early July 2016, the National Retail Federation released the results of a consumer survey where 89% of respondents agreed with the statement, “I think that bank ‘swipe fees’ should remain capped to limit fees to merchants.”

So, the market seems to be finding equilibrium. There does not appear to be a need to abolish Durbin, other than, to put it in the words of Rep. Neugebauer, to “artificially shift over $30 billion in revenue from one industry to another [the other way].”

Unfortunately, consumers will get another bad deal if Durbin is repealed as it is highly likely that banks, using the same rational behavior used by retailers, will not reduce or eliminate the fees they imposed when Durbin was enacted.

Alternatives to Interchange

Durbin has indeed impacted the U.S. payments landscape, but the argument over this law ignores much larger questions: What should be the fair cost of a payment? Who should bear it? And what should be the future of interchange?

The question is not whether interchange should be set by regulators or the free market, but whether interchange should exist at all, both for debit and credit. It would be quite interesting to see consumers’ reactions if merchants could display the following information on a receipt for a theoretical $100 transaction initiated with a World/Premium credit card at a regular (that is, non-supermarket, non-travel) retailer:

“Thank you for your $100 purchase. Please be advised that $2 of the purchase amount was allocated as a ‘swipe fee’ to process this payment. Of the above $2, $1.80 went to your bank (the issuer of the card) for providing access to your funds, 10 cents went to Visa/MasterCard, which provided the network to authorize and settle the transaction between your bank and our bank, and 10 cents went to our bank to initiate and process the transaction.”

Of course, the numbers in the message would be different for each transaction amount and card type, but it is easy to see that consumers would object to how much they are paying their own bank to access their own money (or line of credit), in addition to all the fees they are already paying (annual fees, finance charges, and so on).

No one is disputing the right of issuers and the card networks to charge for their services, but interchange’s lack of transparency, and the autocratic manner in which these fees are set, may have outlived their usefulness.

Interchange’s opacity causes consumers to make choices that may be against their best interests. For example, consumers may select cards with high levels of rewards without realizing that these cards are also the more expensive for merchants to accept, thereby increasing the overall costs of their purchases.

In the Australian debate, it was concluded that rewards programs, funded by interchange, only benefit the few, making these programs a form of cross-subsidy and a regressive tax on all purchases for all consumers.

Further, interchange may no longer be needed to induce banks to issue cards. Finance-fee income covers credit losses, cost of funds, and other costs. Thus, even without interchange, credit card issuance would remain one of the most profitable lines of business for financial institutions.

Nearly 90% of all U.S. credit card transactions are performed on cards issued by the top 10 credit card issuers. In 2015, the credit card industry reported an average return on assets for big card-issuing banks that was more than triple the returns for all other U.S. commercial banks.

Debit card issuers still must continue to issue debit cards (or find other instruments, like mobile phones) to allow consumers access to their accounts, lest consumers go back to using cash or writing checks. Certainly, interchange income will have to be replaced. There are several interchange-free debit schemes around the world, such as Interac in Canada and BankAxept in Norway, where issuers charge their cardholders a transaction fee and without any interchange flowing between acquirer and issuer.

These are but two examples of transparent alternatives that can positively impact U.S. payments’ societal cost. Replacing non-transparent with direct fees would allow consumers to clearly compare charges between different banks for fund accessibility. Those claiming that Durbin negatively impacted consumers should be able to support this argument.

Battle Stations

However, a larger battle looms.

With the appeals court’s recent rejection of the massive Visa/MasterCard interchange settlement, the forces of good and evil (which is which depends on your point of view) are taking up battle stations through lawsuits and Congressional lobbying to favor their respective agendas.

Unfortunately, defining payment policy through lawsuits and Congressional intervention is not necessarily a good thing. First, it creates uncertainty. These issues are litigated over many years, making it difficult to justify investments in new product ideas. Second, when settled (and assuming that there are no appeals), market participants overreact, as noted earlier.

Third, and probably most important, the only participants in the debate are the mega-merchants, the largest banks, and the card schemes, because they are the only ones that can afford lengthy litigation.

Markets do not like uncertainty, and, as we saw when Durbin was introduced, overreactions hurt consumers. Given the high barrier of entry into the debate, who will mind the needs of the small merchants and credit unions? Who will mind the pockets of consumers, who end up paying for everything? And who will be looking at the societal costs resulting from continuing to support archaic payment systems that, because of the economic advantage they offer to one side of the two-sided market, actually stifle innovation?

While it is true that free enterprise can be messy, is this really the best way to run a railroad? The U.S. needs a long-term, coherent, fair, and realistic payments policy that all players can rely on for making rational decisions. Industry experts and enlightened regulators need to step up and define such policies.

Let’s not be duplicitous when calling for a repeal of Durbin. Let’s truly debate the future of U.S. payments and the need for a more transparent way to let consumers know the cost of their payments.

—Rene Pelegero is president and managing director of Retail Payments Global Consulting Group, Kirkland, Wash. Reach him at renep@rpgc.com.