The Consequences of Debit Interchange Price Fixing

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1 The Consequences of Debit Interchange Price Fixing Overview The Durbin Amendment has established a price fixing scheme for debit interchange, implemented by the Federal Reserve. Banks will be forced to offer debit card services to retailers at sharply below cost. The beneficiaries will be giant retail chains, as 1.5% of merchants account for over 80% of debit transaction volume (and the top 100 merchants alone account for 50% of the debit transaction volume). The corresponding harm will fall largely on consumers, as (1) there is no requirement or expectation that retailers will pass along their $14 billion windfall to their customers; and (2) banks, forced to lose money on debit interchange transactions, will be forced to compensate by increasing fees for deposit customers. In effect, consumers will end up paying for a payments system that provides retailers with extraordinary value. Prior to the Durbin Amendment, Congress had not enacted price control legislation for many years. Not only is such legislation inconsistent with basic American free enterprise principles, but it has generally proven to be a failure, producing unintended consequences, stifling innovation and competition, and harming the very consumers the legislation was designed to protect. Discussion The Durbin Amendment instructs the Federal Reserve to set the price that banks and credit unions can charge for debit interchange services. The Federal Reserve s proposed rule does not take into account all of the costs of providing banking services but, rather, only allows banks and credit unions to recover their incremental costs of authorizing, clearing, and settling debit card transactions, with a potential allowance for fraud prevention costs. This is blatant price-fixing in a business-to-business setting that prohibits banks and credit unions from recovering the value they create, or even the actual and reasonable costs they incur, in providing key banking services. Acting under the Durbin Amendment, the Federal Reserve s proposed rule would fix debit interchange fees regardless of transaction size at 7-12 cents per transaction, roughly 80% below today s fees and far below what it costs banks and credit unions to provide basic debit card services. There is no business that can survive being restricted to charging only incremental costs for its goods or services. For example, if the government restricted a restaurant s food prices to what it paid for ingredients and labor, without allowing the restaurant to take into consideration other expenses such as rent, utilities, marketing or management, that business would fail. Banks will lose about 80% of the debit interchange revenue that supports the entire deposit account relationship, and as a result the offsetting cost increases to consumers will be significant. While the primary effect on consumers will be higher prices for banking services, there will also be secondary effects. Many customers will not be able to afford these cost increases and will drop out of the banking system. Payday lender stocks continue to rise, as it becomes clear that the Durbin amendment and other recent Congressional actions will drive bank customers to them. In sum, the Durbin Amendment undoes a generation of hard work to reduce the ranks of the unbanked.

2 There will be other negative secondary effects for consumers such as decreases in service and innovation - because banks are unable to pass along their actual costs. In enacting the Durbin Amendment, many members of Congress were led to believe that small banks and credit unions would be exempted from the harm of debit card price fixing. This is not correct. It is not possible to shield credit unions or small banks from the economic damage created by the Durbin Amendment this is why small banks and credit unions continue to oppose vigorously the Durbin Amendment and the Fed s proposed implementing rule. 1. Products and services should be priced based on value provided not some artificial concept of cost. a. The Durbin Amendment is blatant price fixing that fixes prices based not on value provided or even full and fair costs but, instead, on an artificial and incomplete measure of incremental cost. The Durbin Amendment s limited definition of incremental costs has no economic validity as a pricing metric AND will prevent banks and credit unions from recovering their fair and reasonable costs. b. Retailers have benefitted enormously from the value that banks and credit unions have created in debit card networks by fully embracing and accepting the widespread use of debit cards and by benefiting from the higher sales generated by the proliferation of debit cards. Retailers are not required to accept debit cards but have chosen to do so because they benefit from them in multiple ways. c. Because of the wide usage of debit cards, many retailers have been able to change their business to lower costs and increase sales. For example, grocery stores, big box retailers, gas stations and other merchants have benefited from self-service check-out. d. Consumer adoption of debit has been rapid and significant, and as a result the use of checks and cash has decreased enormously, resulting in a significant reduction in check processing infrastructure and costs. e. Retailers also benefit from the ease with which consumers can access their funds and pay for products and services more quickly; from the ability of retailers to process payments quickly and efficiently, at little or no risk; from lower fraud losses; from faster service to customers; and from faster credit for sales. f. Entire categories of merchants, such as internet retailers and airlines, depend almost exclusively on debit and credit cards. Approximately $1 for every $10 spent on debit cards is spent when the card is not present for the transaction. g. Retailers have a choice as to what form of payment to accept, and many retailers, including grocery stores, have stopped taking checks altogether to reduce costs. Some do not even accept cash (e.g., many parking garages and many airlines for in-flight purchases only accept cards, etc.).

3 h. Retailers argue that cash and checks clear at par, with no additional transaction costs, and debit cards should be priced in the same way. It is simply not true that cash and checks do not have transaction costs. Merchants bear significant costs when processing cash and checks, including the cost to move and store cash and checks, security and insurance, robberies, cash handling fees and fraud. It has been shown through many different studies that it costs merchants basis points to process a cash transaction and basis points to process a guaranteed check. i. The Durbin Amendment s fundamental flaw is that it does not allow for credit unions and banks to capture the value that debit cards create. This type of government intervention into business-to-business dealings creates a dangerous precedent. 2. Definition of costs in Durbin Amendment is incomplete and flawed. a. Debit cards are an innovative payments product that have achieved widespread acceptance in a competitive marketplace and are an important part of the broader checking account relationship. The pricing for the debit card product should not be fixed by the government, but rather by the free market. b. Banks and credit unions expend enormous amounts of money to acquire, maintain and service checking accounts, which are prerequisites for a debit card. Revenues from debit interchange are one way banks and credit unions support the costs of these products and services. c. Revenues from debit interchange allow banks and credit unions to provide a number of free and integrated services including: free statements, free 24/7 customer service, free on-line banking and bill pay, unlimited access to bank branches and ATMs, rewards programs, 100% fraud protection on debit transactions, and similar services in addition, of course, to free debit cards themselves. All of these services encourage consumers to use their debit cards, to the benefit of merchants. Without reasonable debit interchange, banks and credit unions logically and appropriately will be required to charge consumers for these services. d. The Durbin Amendment instructs the Federal Reserve to consider the incremental costs of authorizing, clearing, and settling debit card transactions. The data recently collected by the Fed shows that these costs are only 17% of the total cost per debit card transaction. e. The proposed rule would not allow banks to recover many costs currently covered today by interchange such as funding costs, overdraft losses, fraud prevention costs, fraud losses, billing and collection, customer service, data processing, protection of consumer data, compliance costs, card production costs, and statement production and mailing. f. Checking accounts cost banks and credit unions $ annually per customer. Although these costs include those necessary to support debit card programs, most of these costs, including fraud losses, are excluded

4 from the definition of costs the Fed may consider in its rule. For example, in 2009 the industry incurred approximately $1.4 billion in fraud losses related to debit card transactions, but will not be able to recover any of these costs under new fixed interchange fees. 3. Consumers will see higher prices and new restrictions on banking services. a. To cover the costs that merchants pay now for the benefit of accepting debit cards, banks and credit unions will be forced to increase fees, charge for services that are now free, and limit ways consumers may use their debit cards. i. The Fed s proposal caps debit interchange fees at 7-12 cents, regardless of transaction size. Yet banks must generate a considerably higher level of revenue from interchange fees to support their consumer products and services. If they can t, banks and credit unions will need to charge significantly higher fees to cover their costs of providing basic banking services and/or charge for services that currently are provided for free. Interchange regulation in Australia has led to higher fees and fewer rewards for consumers with no conclusive evidence that consumers have seen any savings. The result will be a $14 billion wealth transfer from consumers to the country s largest merchants. ii. Additionally, large debit purchases may become prohibitively expensive for banks and credit unions to offer due to the risk of higher fraud losses on larger transactions; hence, some banks may restrict debit cards to low-dollar purchases. iii. Debit cards may be restricted in other ways. Merchants who take card information over the internet and phone, where fraud costs are higher, may no longer be allowed to accept debit cards for those transactions. Or banks and credit unions may eliminate or limit the guarantee merchants currently receive on authorized debit transactions. iv. Consumers have come to depend upon the convenience and safety of accessing funds in their checking accounts in millions of locations, in attended and unattended transactions, 24 hours a day, seven days a week. Transaction pricing at the levels contemplated by the Durbin Amendment could result in major disruptions to the current working of the worldwide payment system. 4. Many Americans will not be able or willing to pay for higher cost banking services, and may well be forced out of the mainstream banking system. a. Middle-income and working-class Americans will not be able to or willing to pay costs for banking services, and lower-income Americans will be forced out of mainstream banking due to higher costs.

5 b. These customers most likely will be forced to resort to more expensive and less regulated check cashers and payday lenders for banking services (and be more impacted by pricing changes described above in 2c). 5. Price fixing will reduce innovation, and lead to a less safe and secure payment system. a. The financial services industry has invested billions of dollars over many decades to build an infrastructure that facilitates the use of payment cards on a global basis and has effectively migrated trillions of dollars worth of transactions from paper to electronic form. b. Fixing prices at 20% of current rates will stifle any future investment and innovation that benefits consumers and merchants (e.g., mobile payments, guaranteed fraud protection, photo card, contactless payments, account alerts, etc.). c. Additionally, because debit cards will potentially have more limited acceptance (e.g., low dollar transactions at only certain merchant types), customers will be forced to use higher risk payment methods (e.g., cash and check). In addition to price fixing, the Durbin Amendment instructed the Federal Reserve to require banks and credit unions to process debit card payments on multiple networks and enable or allow merchants, not customers, to choose which network to use for any payment. These changes will: o Significantly reduce debit interchange for smaller banks and credit unions, which are not exempt from these requirements. o Further and unnecessarily increase costs for customers and small to midsize businesses because to comply with this unnecessary mandate, banks and credit unions will be required to invest in new and duplicative technology, systems, risk management tools and other infrastructure and small businesses will have to invest in infrastructure upgrades. o Potentially increase fraud and compromise data security in an unprecedented era of cyber attacks and coordinated efforts to steal and misuse cardholder data and identity as banks and credit unions are required to spread their volume over multiple networks. o Deprive issuers of the ability to tailor unique product and fraud protection offerings most suitable to their business goals and their customers needs. Rather than issuers being able to design programs most suited to them these provisions commoditize payments in an effort solely to drive down merchant costs. Changes of the magnitude resulting from the Durbin Amendment, such as government mandated price-fixing and changes to the structure of the payments market, should not be imposed without serious thought, analysis and study. These Dodd-Frank provisions will have significant and long-term consequences to the financial system and the larger U.S.

6 economy, many of which cannot be determined today, and should not be implemented without careful study and analysis. Recommendation The Durbin Amendment was enacted through an extraordinary process: o Debit interchange had nothing to do with the financial crisis, and this provision had no place in the Dodd-Frank Act; o There was no consideration in any Congressional committee; o There was no vote in the House of Representatives; o There was only scant discussion in the Senate and that was by the lone sponsor of the amendment; o There was no analysis presented to Congress of the impact on consumers, the banking system, or the overall economy; and o There was no analysis of whether the $10 billion asset "safe harbor" would avoid harm to community banks and credit unions. We urge Congress to take the following steps to allow Members to give it due consideration and examine likely but unintended consequences, in the name of consumers and basic fairness: o First, delay the effective date for the Federal Reserve s rulemaking, including the interchange fee and network exclusivity restrictions, by two years. o Second, hold a series of hearings that include analysts, economists and regulators who can describe the likely effects of this provision. These hearings would also give retailers the opportunity to testify about how much of the savings from below-market interchange costs will be passed along to their customers. o Third, direct the Treasury Department or Government Accountability Office to review and analyze the product of these hearings, and present its analysis to Congress for review and debate. o Take appropriate additional action as suggested by the report.