The Fed's Final Debit Rules: Did Anyone Win?

By David S. Evans (Founder, Market Platform Dynamics)

June 30, 2011

- Fed Memo on Debit Regulations

- Fed's Full-Length Report on Debit Regulations

Whew, at least it’s over! Two months after they were due under the Dodd-Frank Act and about three weeks before they were supposed to go into effect, the Federal Reserve announced the final rules for regulating the debit card industry late yesterday afternoon. Hopefully, the Fed staff will now get to take a well-deserved vacation having spent late nights and weekends presumably pouring over the 11,000 or so comments they got and figuring out what to do. Everyone else probably has a lot of work to do.

Yesterday, the Board agreed on a cap of 21 cents per transaction plus .05% of the transaction. That works out to about 23 cents on a typical $38 transaction. That’s almost double the 12-cent cap and more than triple the 7-cent safe harbor (and effective cap for most transaction volume) alternatives the Board had proposed last December. The Board adopted as an interim measure a 1 cent per transaction kicker later for fraud prevention costs. The Board also agreed that issuers could satisfy the routing requirements if they had unaffiliated signature and PIN networks; it rejected the alternative of requiring two unaffiliated signature and two unaffiliated PIN networks.

There’s going to be a lot of discussion about who “won” the fierce battle over debit interchange regulation. The answer: NO ONE! (I qualify this below a bit.)

Merchant trade associations are howling. One can see why. Based on an analysis I had submitted to the Fed, together with my colleagues Bob Litan and Dick Schmalensee, large retailers would have gotten a windfall—money they would have kept and not passed on to consumers—of between $17.7 and $20.4 billion over the first 2 years of the rate reductions proposed last December. That’s been slashed to $11.4 billion. Large retailers are out an estimated $6.3 billion dollars (the difference between the $17.7 they would have gotten under the 12-cent cap and the $11.4 they will get now) that they thought they might have had in the kitty.

Consumers shouldn’t be happy either though. Yesterday, they heard the Board staff and the some of Governors more or less admit that consumers were going to pay higher fees for checking accounts, lose free checking and lose card rewards. They heard no assurances they would get that money back through lower merchant prices. I’ve calculated based on the work I did with Litan and Schmalensee that the 22+.05% rule will cost consumers up to $22 billion over the next two years; that’s about how much they would lose if banks and credit unions pass on all of the deficits created by the loss of fee revenues—it will probably be less than this but not a lot less. Of course, the good news for consumers is they would have done even worse under the Fed’s December proposals.

Small banks and credit unions should be especially unhappy. In its rush to get the Durbin Amendment through Congress, it said banks and credit unions with assets of less than $10 billion would be exempt from the interchange fee regulations but then didn’t actually provide any method to enforce it. The Board of Governors and the staff all seemed to conclude that there was serious risk that the small institutions wouldn’t get the benefit of the exemption. Of course, the small financial institutions have a much higher floor on debit interchange fees than they would have gotten under the Fed’s December proposals. That’s especially important for them, because their debit costs are a lot higher than the big institutions.

Banks probably aren't so happy either. At least for the next year, they aren’t going to be able to raise fees, or cut services enough, to fully recover their lost revenues and profits. And they are still going to have to unravel a lot of the banking practices that have helped consumers over the last decade, including free checking. Of course, it could have been a lot whole worse, and few are shedding crocodile tears for the big banks.

Congress and the political process is a big loser. Yesterday, the Board of Governors for all intents and purposes unanimously said that they were forced to implement a flawed law. One refused to vote for the proposal altogether, but four Governors qualified their votes by saying, more or less, that the staff proposal was the least bad thing they could do given the language of the Durbin Amendment. The Governors were variously worried about the impact on small banks and credit unions, on consumers, on innovation and on the unintended consequences of imposing price regulation.

There are various participants who won because they came out unscathed, like three-party systems that escaped the proposal to regulate their merchant discounts and apply the routing rules to them.

Although none of the major stakeholders won, consumers, banks and credit unions did far better than many thought they would based on the Fed’s earlier proposals.

I watched both the Board of Governors meeting on December 16, 2010 and the meeting on June 29, 2011. The contrast in tone, demeanor and results was striking. The Board and the staff appear to have become increasingly concerned that the proposed reductions in interchange fees would harm small banks and credit unions who wouldn’t get the benefit of the reductions and consumers who would face higher fees. But they were required by the statute to adopt rules by July 21, 2011 At least one of the Governors pointed out they just didn’t have a choice.

Their task—and it is clear from their statements that this is how the Board and staff saw it—was to adopt rules that would do the least damage given the statute they were given. They had to play a bad hand. Their solution was to use the latitude the statute gave them to consider what costs to include in their calculations. They stuck with the earlier framework for the 12-cent cap, which was based on the 80th percentile of large issuer costs. But they greatly expanded the cost basis for calculating the fee cap. That led to the increase from 12 cents to 21 cents, and then, they added in the compensation for fraud losses that produced the 5 basis point kicker and then the penny for fraud prevention. That change helped mitigate the damage to small banks and credit unions as well as to consumers.

The Federal Reserve Board will probably end up being criticized by everyone. That’s unfair. The staff was given a highly problematic statute, a monumental job and an inflexible deadline for completing it. The Board had to balance what their lawyers were telling them the statute required and what their economists were telling them would happen under alternative rules. It took courage for the Board to back away from its earlier proposals. It doesn’t do that a lot. Everyone should give the Board a lot of credit for how they have dealt with a difficult situation, even though everyone will likely find something to disagree with in the more than 400 pages of their final rules and analysis.

Unfortunately, yesterday did not end the debit card controversy and provide certainty over how this industry will be regulated going forward. Too many stakeholders have reasons to keep complaining. Lawyers and lobbyists don’t need to worry about hitting the breadlines.

For now though everyone in the debit card industry can enjoy their barbecues and fireworks, knowing what the rules are at least for now.

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David S. Evans is an economist and a business advisor to payment companies around the world. His recent work has focused on helping companies create, ignite and profit from payments innovation. He is the originator of the Innovation Ignition Framework®, a tool provides a systematic way for companies to evaluate and implement innovative ideas and achieve critical mass. David is the Founder of Market Platform Dynamics. Read More

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