Richard Schmalensee: The Economic Impact of Durbin on Consumers and Small Businesses (Transcript)

Full Coverage: Debit Stakeholders Face Off at PYMNTS.com Durbin Conference

DAVID EVANS: I’d like to turn now to Dick Schmalensee. Dick is now the Howard Johnson Professor of Economics and Management at MIT. For about a decade, Dick? – you were the Dean of the Sloan School a decade, and he was the Dean of MIT Sloan School, which I’m sure most of you know, is one of the top business schools in the world, and an even tougher business school at the end of Dick’s tenure than at the beginning of it.

He spent one stint here in DC serving as a member of Bush Number One’s Council of Economic Advisors. Those of us like me who are in the economics business know Dick as one of the world’s leading scholars in economics, and particularly, in the field that’s sometimes known as industrial economics or industrial organization.

He’s written some of the leading papers on the economics of interchange fees, and I hope most of you know – and if you don’t, you should go to Amazon.com and learn this – that he is the co-author of Paying with Plastic, the Digital Revolution in Paying and Borrowing. Did I mention, that’s on Amazon.com? And we need a sales booth, because the last edition was 2005, which isn’t exactly a – anyways, you should buy the book anyway.

In any case, it is now my pleasure to turn this over to Dick.

DICK SCHMALENSEE: There’s an instability here. David neglected to mention, of course, that he is the co-author of Paying with Plastic, but just his excessive modesty that prevented him from doing that.

The work I’m talking about today is joint with David and Bob Litan. It was funded, as Martin indicated, by some large financial institutions. The opinions, the calculations, are mine.

In a way, I’m going to do some of the plumbing behind Martin’s earlier talk, with numbers and some of the arguments spelled out. So we have 427 slides to go through. I’ll try to start at the beginning. I assume this is a well-informed audience, but if you will forgive me – I wonder if you’ll forgive the clicker – here we go.

So here’s the basic issue, the basic facts. Debit cards are tied to checking accounts. They’re part of the bundle of services provided with checking accounts these days. Interchange fees amounted to almost $16 billion in 2009. The Fed’s proposal – and it is a proposed regulation, an implementation of the Durbin Amendment, would cut those, as Martin indicated, by between – depending on which proposal is adopted, and how the 7% – $0.07 safe harbor is interpreted – between 73% and 84%.

So, you have a situation where banks and credit unions lose, merchants win. Does anybody else care? And I’m going to argue that there are pretty straightforward reasons why other people care.

Now it could be a wash. Right? It could be a wash, under – for the rest of us, under two conditions. First, banks just eat the loss, merchants put the gain in their pockets, prices don’t change for anybody else. It’s a fight between big guys.

The other way would be that banks instantly pass through those costs. The cost increases, revenue – merchants instantly pass through the cost savings. So these prices go up, these prices go down, to a first approximation. It’s a wash.

And the Fed sort of – staff sort of stopped there. Martin had this quote, it’s hard to anticipate what the overall effect will be. Well, it’s not that hard. We looked at it. There’s some basic economic principles that let you make broad qualitative, and we think reasonably quantitative, predictions.

And to be clear, this isn’t an evaluation. This isn’t banks should do, merchants should do. This is old-fashioned economic prediction. This is positive economics. Here’s what’s likely to happen.

We make – and we’ll argue, I’m going to make the arguments behind these assertions. Retailers will respond slowly, in large part, because it’s a tiny decrease in cost – spread widely, but a tiny decrease in cost of any particular item. It won’t trigger repricing. And because some merchant categories are not highly competitive, even in the long run, you don’t expect the full gain to be passed through. Certainly not in the short run, maybe not in the long run. And again, Home Depot, in a moment of candor, made that point in an earnings call, that this was a benefit, would go into the pocket.

Banks and credit unions, on the other hand, take a big hit. This, to them, is a large hit. To a large hit, in a competitive industry, you get quick, nearly full response. This is not made-up rocket science, this is a large literature, and it’s what you hear from the banks themselves. We’ll go into more detail, but they’ve made changes, they’re planning further changes, so basic economics.

And what that means is, it’s not a wash for consumers, that bank fees go up, merchant prices don’t come down – at least, not quickly – and at least for the first two years, on which we focus, it’s pretty straightforward to see that consumers are harmed.

What about small business? Small business is a little trickier. You have to look a little bit behind the surface. But it’s not that hard, either. And again, I will go into more detail on these, but most small businesses have checking accounts, just like all the rest of us. But not all small businesses take debit cards.

So if you have a checking account and you don’t take debit cards, you lose. That’s straightforward, because there’s no gain. And we’ll argue that certainly in the short run, even small businesses that take debit cards, because of their contractual relations with the merchant acquirers that process their transactions, they will not see a gain.

So again, particularly in the short run, small merchants will not be helped. It’s – you normally think of small businesses as retail, because they’re visible. My wife is a one-person marketing consulting firm. She is a small business – she is a female owned small business, for that matter. She does not take debit cards, oddly enough.

Pure harm. Checking account goes up, and of course, that’s why I’m here. So – which is what I tell her.

So let’s talk a little bit about some of the plumbing in debit cards. As I said, debit cards are part of the bundle of services provided with checking accounts. You look at – and again, Martin alluded to this.

From the point of view of the bank, you provide a bundle of services, you put prices on that bundle of services. Some are free, some are not free. What the bank wants to do is, profitably price checking accounts. To the extent that debit cards are a major source of revenue, then checking accounts held by people who do a lot of debit card business are profitable. To the extent that debit cards are not a major source of revenue, because the fee is cut or for whatever reason, then those customers are not as profitable.

Banks are in business to make money. If you change the profitability of checking accounts, if you change the profitability of different customer categories, banks will respond.

Debit fees are a major source of revenue. They’re about 20% of the revenue from checking accounts. So if you make drastic cuts, you have to expect a response.

The – and I’ll be a little bit more detailed. This is the obscure part. I will just spend a minute on interchange fees and four party networks. David and I and others have – and many of you here have been hip-deep in this for a long time, but I have to say, if you talk to most people about interchange fees, they glaze rapidly.

So, networks – Visa, MasterCard, STAR, the other – the various networks that offer debit cards of various kinds, set fees. They set the interchange fees that merchants pay and issuers receive. It is a pass-through. These networks used to be owned, used to be basically cooperative operations of banks. They aren’t anymore. They are standalone, Visa, MasterCard – all of these are standalone, nice entities.

The merchant acquirers charge a discount to merchants that obviously has to cover the interchange fee that they pay to the network, and their costs, normally, plus a markup. So merchants see a discount that is the interchange fee plus what the acquirer keeps plus what the network keeps. The issuing bank – right? The acquirer takes its piece, the network takes its piece, the network passes through the interchange fee to the bank that issues the card.

There are two different kinds of contracts between merchant acquirers and merchants, and this is the – an important part of the small business story. Large merchants typically have contracts that say – about 25% of merchants, about 75% of debit card volume, they have so-called interchange fee plus contracts. So, the contract will say, we will charge you the interchange fee plus X. So that when the interchange fee changes, for whatever reason, it gets passed through, dollar for dollar.

Small merchants typically have – there are undoubtedly exceptions to all of this, but small merchants typically have these blended contracts. Whatever card is put in the machine, whatever the interchange fee happens to be, we’ll just charge you the average, and we’ll charge you a fee of X. There is no automatic pass-through during the life of the contract, and there may not be a pass-through otherwise, but there is a blended fee – interchange fee not broken out.

So this affects what happens to large and small businesses, right? Small business – large businesses will see a change immediately. Small businesses will see a change when their contract is renegotiated.

OK. So, second – or third background point, this is a big hit. This is a big hit to the banks in particular. Banks get about $16 billion in 2009 of debit interchange revenue. Between an 84% and a 73% reduction, this is a significant reduction in fees over the first 24 months. And I’m going to talk a little bit about the small institutions later.

So how do you think about how banks react, and how merchants react? Well, this comes from a rather large literature in economics. In highly competitive industries – sort of regardless of what the demand curve, if you’ll pardon me, looks like, a big increase in cost or a big decrease in cost gets passed through fully. And it gets passed through quickly, because if you’re in an intensively competitive industry and your costs have gone up, you better raise prices, or you’re losing money and you’re gone. If your costs go down, well, you’re going to have to lower prices, because your competitors are going to lower prices. Competition will force that.

If industries aren’t highly competitive, however, there’s no guarantee of a full pass-through. You could get more than 100%, you could get less than 100%. It depends on the details of the market. Empirically, most evidence suggests somewhere around 40% to 70% long run pass-through.

So that’s competitive versus not so competitive. Regardless of how intensively competitive an industry is, though, apart from the textbook, little changes in cost don’t get passed through immediately. It’s a hassle to change prices, particularly retail prices, when you’re dealing with consumers. It’s a hassle, it’s annoying, you just don’t do it. Retail prices for most products stay constant for months at a time, except for deals, of course. But list prices in supermarkets don’t move quickly. And other retailers, they don’t move quickly in response to small changes. Again, much studied, well documented, short-term.

It also makes sense, right? If you’re selling an item for $10, $9.99, your costs go down by $0.02 – which is the order of magnitude we’re talking about here – do you immediately reprice to $9.97? Probably not.

OK. So that’s the basic background. Now, let’s look at the two sides of the market. Let’s look first at banks. What can you predict banks are going to do?

Well, the argument is pretty straightforward. It’s a big hit in a competitive industry, so you would expect… that you get a full, quick pass-through, one way or another, adjusting prices for checking accounts. But we have history. We’ve seen what happened when debit card revenue went up, and we’re beginning to see, with the Reg E change, what happens when revenues for checking accounts take a hit. So let me walk through the various parts of that argument.

But that’s the argument, that in principle, it’s a big hit in a competitive industry, so you expect a quick, thorough pass-through, and recent evidence supports that, that claim.

So is it a big hit? Yeah, it’s a big hit. It’s around a 20%, 24% reduction in checking account revenues – not trivial, even if you just look at retail banking overall. This is not something businesses can ignore. I mean, like it or not, you don’t absorb this by reducing executive bonuses. You reprice products. That’s what you expect to have happen. Banks and credit unions can’t ignore it, aren’t going to absorb it, have to do something.

One reason they have to do something is, again, if you look at banking, it – what’s interesting is, there’s been a lot of consolidation at the national level, but in fact, at the local level, where it matters, banking markets are SMSA, metropolitan area sized. They’re still pretty competitive. Thirteen banks and credit unions in Georgetown, 83 in the DC metro area – not all convenient, not all large, but ask yourself, how many theater chains – I don’t know the DC area in this regard – how many theater chains, how many supermarket chains, how many competitors for Wal-Mart, how many competitors for Staples or Home Depot? They don’t necessarily look like that.

So by any reasonable standard – and again, this is something that’s been analyzed a lot, in connection with bank mergers, this is a competitive industry.

So what’s the evidence tell us? Well, Martin had the bars on this chart. That’s debit card transaction dollars. And it’s risen dramatically. If you go back farther, to the mid ’90s, you have to really look with a microscope to see those dollars. It’s risen dramatically.

One of the things that – and that has translated into banks’ revenue. This is transaction dollars, not bank revenue, but there has been a similar increase, mostly driven by volume, not driven by fees, in what banks have gotten from debit cards. Look at the line. The line shows a dramatic increase in free checking, from under 10% of accounts to well over 70% of accounts, in a short period of time

Now, is it causal? Well, it has to have an impact, right? Because if you make having – giving a checking account to somebody more profitable, then you’re going to lower the price of checking accounts, to get them in more people’s hands. If you can make money on the fact that they use debit cards, well, you want to get debit cards out there. The way you get debit cards out there is to lower the price of the checking account.

So can you prove a causation? Not really. Is it plausible? Yes. Would it be stunning if this – something like this didn’t happen, with the rapid rise of debit card income? Yeah, it would be stunning.

Lots else happened besides the rise of free checking over this period. Lots more ATMs, lot more branches – again, it’s predictable. You’ve made giving somebody a checking account more profitable, so you start to compete harder for people to have your checking account.

More ATMs and branches, all of a sudden, online banking is free and widespread and easy. Online bill payment is widespread and free and easy. Mobile banking is beginning to grow. This is what you do when you’re competing for profitable customers. You add services, you cut prices. The interchange has made checking account customers more profitable.

The changes to Reg E – again, not evaluating, but the changes to Reg E reduced the profitability of checking accounts, and all of a sudden, you begin to see a cut in free checking. Again, as you would predict – as you would predict. That was a big hit. Checking accounts become less profitable to banks, you raise the price – you raise the price.

You also make some other changes, and here are some quick changes made in 2010 by major banks in response to – the press release might not have said so, but shortly after the Reg E changes in July, and to some extent, anticipating what might have come from Durbin, and you see basically there are service fees – not necessarily for high balance accounts. High balance accounts are still profitable. But an account with a low balance and a lot of debit card usage, or low balance and a lot of overdrafts, is suddenly not profitable. So you raise the price. Not necessarily for everybody, but you raise the price.

And they did it quickly, right? This is a few months after the Reg E change. December is sort of just when the Fed began to announce.

So the history says that large banks are going to do what you expect large banks are going to do. Now, what about the small banks? Well, community banks – and again, this is survey evidence, but community banks say they are contemplating significant changes – increase in charges, monthly fees for debit cards, eliminating rewards. Why?

Well, Martin touched on this, and there is a little ambiguity here, but think about it. Networks need to compete for issuers. The networks have said, yeah, we’ll give this set of customers high interchange – you, of course, have to get low interchange. But they don’t have to give them high interchange.

And if I’m a large bank, I will be talking to the network, the networks, about giving a great deal to my competitor across the street. That’s competitive pressure one. Competitive pressure two is, of course, merchants may – merchants have the incentive to rout against, to discriminate against, cards that are going to have high interchange. How effective will that be? I don’t know, but at least the community banks are nervous. The small banks and credit unions are nervous, and they know the market better than I do.

The Fed’s staff were asked about this, and you see the quote on the right. Robin Prager, one of the leading economists in this area at the Fed, said – if you read the entire quote, of which this is an excerpt, said, sort of, we don’t know. Maybe the small banks won’t get a better deal, even though they’re formally exempt. Small banks don’t think they will. The Fed thinks it’s plausible. I think the best bet is, after things shake out, they won’t. Or they certainly won’t get the kind of difference that you think.

So in response to the Durbin Amendment, the large banks have made, are planning to make – they’re raising fees, slashing services. And I love the quote on the right. Jamie Dimon says, exactly right, if you – you’ve got to make money on lunch, and if you don’t let me price soda, I’m going to have to raise the price of hamburgers, because I have to make money on lunch. So it will all be priced, and in fact, it’s – they’re moving rather quickly to price new fees, charges on checking accounts, and so forth.

And you’re going to see – it’s not clear, and you will see different banks do different things. So is it clear there will be a price for debit cards? I doubt it. Will there be charges for basic checking for low balance accounts? Yeah, that seems pretty plausible, just on the economics. Will there be restrictions on transactions that have a higher than usual risk of fraud? Large debit card transactions, card not present transactions over the Internet – yeah, because you’ve tilted against the profitability of those transactions.

So each bank will do something different, but one way or another, you expect checking accounts to be made less attractive overall, because they’re now less profitable, and specific restrictions on various debit card features that lead to high cost or high fraud loss. Like – you buy a car with a debit card. Hmm, might well be a fraud. You do a lot of card not present Internet transactions? Hmm, that’s risky stuff. Banks can afford to be relaxed, they will be less relaxed.

So it’s clear, I think, that consumers – that banks will pass through their costs one way or another, through fees and rules associated with checking accounts. The thing that seems clear to me is that low income individuals are going to be hit particularly hard.

If you look at the expansion of free checking, and one way to see exactly how much it penetrated, how much free checking pulled in low income households, is to look at payment card access. You look at households with incomes below 50% of median income, how many had access to a payment card, and credit card penetration didn’t change over this period. Basically 45% in 1995, 67% in 2007, on the data we have available.

What happens when, as we saw in these earlier slides, free checking is rolled back? Well, it’s – again, different banks will do different things, but it would be astonishing if the rolls of the unbanked didn’t rise. It would be astonishing. Because lower income households who have low balances but high debit card usage are no longer as profitable. It’s straightforward.

OK. What about the other side of the business? What about merchants? So the merchant argument is, again, just to spell it out here a little bit, it’s a small gain. Less than $0.02 on a $10 item. You don’t reprice from $9.99 to $9.97 immediately. You simply don’t pass things through quickly.

Will things get passed through eventually? Well, in competitive categories, yeah. You know, competition drives profits to competitive levels, so ultimately, in competitive merchant categories, those savings will get passed through to consumers. But a lot of merchant categories aren’t that intensely competitive. Again, go through the list that I kind of sketched out. Think about theater chains, supermarket chains – again, this varies from area to area, so there may be 12 of each in Washington. But supermarket chains, theater chains, competitors to Staples, competitors to Wal-Mart, competitors to Home Depot.

And in some categories, they just aren’t intensely competitive. Again, this has been studied. So in those categories – first, they won’t pass through a lot in the short run – nobody will. But in the long run, they may not pass through 100% of the savings. They may be substantially below.

Small merchants – I talked about the difference in contract terms between small merchants and their merchant acquirers, and large merchants and their acquirers, small merchants won’t see an immediate cost saving, just because of the nature of the contract. I mean, you can imagine things being renegotiated, but as things now stand, there is no automatic cost saving for small merchants, so they may well not see any savings to pass on. Though the result is, you’re not going to see things passed through quickly.

Again, large merchants – so let’s distinguish now between large and small. Large merchants have interchange fee plus contracts. They will see cost savings as soon as the price gap goes into effect, but they’re not going to reprice on tiny cost reductions, and in some categories, there won’t be a full pass-through even in the long run.

To try to sort of put a hard number on this, how much in the short run, how much in the long run, how fast, would require a lot of work, which we haven’t done. But ballpark – but studies that have looked at particular cases – again, as I said, earlier, tend to get sort of the 40% to 70% number for the long run pass-through.

So if you just do some horseback numbers, again, if you look at large merchants’ retention, because they respond slowly, and because, in part, in the long run, they don’t respond fully, again, 90% in the first year, 50% in the second year. Move the numbers around – I think the 90% is right, just because of how long it takes to get price changes done. 50%, you can go plus or minus a little bit, but it’s probably about right, given long run pass-through rates.

You get a two year windfall of on the order of $17 billion to $20 billion for large merchants, because they don’t pass it through. And again, in a moment of candor, Home Depot said as much.

So, small merchants, the story is even a little more complicated than I indicated. This slide lays it out in all the detail. So first, the acquirers, with which merchants have arrangements – as I said, they don’t pass through automatically savings in interchange. That’s not how the contracts are structured.

But second, that business, for small merchants, is not that competitive. For large merchants, yeah, that’s a very intensely competitive, very small margin business. But for small merchants, switching process, switching acquirers, switching processors, has a cost. Acquirers want to make sure a small merchant is credit worthy, so there are frictions in that business. How big, eye of the beholder, but not trivial. Frictions for small merchants trying to switch acquirers.

So as long as the competition for the business of small merchants is less than intensely competitive – for large merchants, it is intensely competitive, but for small merchants, not so much. You might not even get full pass-through in the long run.

And again, there are analyst statements – I don’t have the quotes there – that basically suggest that merchant acquirers will get something of a windfall, at least in the short run, from small merchants.

So what do you get? This was sold, in part, to help small businesses, and some small businesses have bought this. But it’s really hard to make the economic case for most of them. For most of them, they have checking accounts. The argument that they will lose there is hard to quarrel with.

So they lose, and again, this is an estimate of how much per account. If you don’t take debit cards, there is no compensation on the other side. If you do take debit cards, the question is, when do your fees – when do your discounts, your fees, go down, and do they go down fully? So, some will get reductions in debit card fees. How soon, a little unclear. So it’s very hard to make a small business – some small businesses will benefit, but most, it’s hard to see how there’s a benefit here.

So the summary is pretty straightforward, and again, we haven’t been doing high powered economics here. This is straight out of 101. Consumers lose, particularly in the first couple of years, because the fees of checking accounts go up, retail prices go down by less – again, it could be a wash, if everybody responded – both sides responded the same way, but the economics say they won’t. There’s – not in their incentives.

Small businesses will lose the most, because, again, they came in – or, sorry. Lower income households lose more, because they came into the banking system with the rise of free checking, and with a reasonably predictable decline in free checking and other fees, they are likely to become unbanked, they are likely to lose debit cards, and so forth. Hard to quantify – real hard to see how that doesn’t happen. A question of how many.

Small businesses, if you have a checking account and you’re a small business – my poor wife, the fee goes up. You don’t take debit cards, there’s no other benefit. If you do take debit cards, the benefits come to you slowly, and perhaps not at all – perhaps not fully. There will undoubtedly be some benefit.

But of course, if you have Wal-Mart stock, it’s a good thing, because we get a windfall – they will get a windfall, again, on our rough numbers, of on the order of $20 billion. You can quarrel, could be $15 billion, but a significant windfall.

Thank you very much.

EVANS: Thank you, Dick, for that non-controversial thought.

SCHMALENSEE: Just straightforward economics, David. Just basic stuff.

TODD ZYWICKI: Dick, Todd Zywicki from George Mason Law School. On the last slide, it seemed like you were missing one major winner from the Durbin Amendment, which will be pawn shops, check cashers, and the other sort of underbelly of the consumer finance system – prepaid cards, Kardashian card, which was even – they finally found something that’s too distasteful for the Kardashians. But that whole sort of motley assemblage of alternative financial products, seems like they’re going to be a big winner once Senator Durbin drives all of these people out of the banking system.

SCHMALENSEE: We didn’t look explicitly at the underbelly of the finance system, but I find it hard to quarrel with that question. (laughter)

PARTICIPANT: And one question that I was thinking about is, this might affect the fuel industry. I’m wondering if this – if they might treat debit the same as cash. I guess they’re not supposed to charge a different rate between cash and credit, but with the – at fuel pumps, you might be seeing it.

SCHMALENSEE: Well, they can. They can now. There are stations that I go to that have a cash price and a credit price, and you could imagine a cash and a debit. It depends on the mechanics of being able to do that. But they might well, they might well. I don’t have a thought about it.

Merchants now are pretty free to charge different prices. There are transaction costs that usually make it difficult to even distinguish between cash and credit, or between PIN debit and credit. How that might evolve with regulation of interchange fees, I don’t know. I know it could happen.

TONY ALLEN: Tony Allen, ProPay, a payment processor. Since we have a situation where consumers have the choice of using debit cards or credit cards, and credit card interchange is not going to change, what would deter the banks from increasing interchange on credit cards to compensate for the loss of income on debit card transactions?

SCHMALENSEE: Well, let’s remember, it’s not the banks making the decisions – it’s the networks. And the networks have obligations to their shareholders. And the networks – they don’t see interchange. So interchange plays a balancing role here. They compete for issuers, they compete for merchants.

How credit card interchange would change, if I had to predict, I’d predict a little decrease, just because being too out of line with debit runs a risk for the networks. But that, I haven’t looked at hard.

ALLEN: Thank you.

SCHMALENSEE: But the banks would obviously like it to go up, but it’s not the bank’s call. It’s not the bank’s call.

ALLEN: Right, thank you.

SCHMALENSEE: Either this is the most polite audience in town, or I have gone way beyond my usual persuasive ability.

BOB BALDWIN: Hi. Bob Baldwin at Heartland Payment Systems. Your slide on the impacts, or the changes in free checking, was quite evocative. What – do we have any sense for how significant the reductions in income to the banks were as a result of the Reg E changes? I think that the 2010 data on free checking, since the Durbin proposal – the Fed’s regulation didn’t come out until December. I think most of it should be attributable to the economy plus Reg E.

So do we have any sense at this point – it’s early, still, but for what the impact was? Because that could be instructive on what could happen in the magnitude of the reductions that you’re talking about.

SCHMALENSEE: We tried to look at that, but remember, it – customers could opt in to overdraft, to have – so the default was changed. And we really don’t know how many customers, checking account holders, made what choice.

So we did try to get a sense of that, but we haven’t been able to. I mean, maybe somebody has done it. We tried to.

It was clearly not a trivial – whether it was larger or smaller than this, I just don’t know. I just don’t know. And we’ll see it, presumably, when we have 2011 data in our pocket, and we can see what happens to those fees, and we can start to do horseback judgments.

Even 2010 data will probably not be – and you need data, because of the consumer choice aspect. 2010 data won’t be enough, because it was probably – there was some churn in a few months, as customers made choices.

So I’d wait to 2011, which is a little too late for this purpose. (laughter)

HENRY PALMER: Hi. Henry Palmer again. I am an attorney in private practice. I asked a question earlier in the day, and perhaps I identified myself as someone who is not on the banking side of this issue, so I am having a hard time to formulate only a single question. You sort of lost me at, I’m happy to be here. (laughter)

SCHMALENSEE: Is there a limit on the number of questions per questioner? (laughter)

PALMER: Let me just think a moment about – I had a question, I sort of let it slip away. The bank – you talked about bank checking accounts, and you talked about various different components of checking accounts. There are checks, there are debit cards, etc. And you’ve indicated that if banks lose revenue on the debit card side, they’re going to have to make it up somewhere, and that’s going to be probably on the checking fee side.

SCHMALENSEE: Well, what I said was that debit cards are part of checking accounts. It wouldn’t surprise me if what happened, especially given what the changes that have been announced, if among the changes were a rollback of free checking, it looks plausible. But banks will make their decisions how to recoup. But they will recoup.

PALMER: I guess my question is, isn’t there a larger view of the consumer – or, of the consumer who has a checking account at a bank? It’s a relationship. It’s not just a checking – just as the banks have tried to make a case that they need to make a profit on debit cards, which is simply a means of accessing a consumer’s own money in a check, in a checking account, that’s really larger than to the debit cards. It’s an access to their own money in the checking account. The checking account is a very valuable piece of the banking relationship.

It also brings to the bank the people who it wants to make loans to, involved in other products that it has to sell, so just to look at the checking – even to look at not just debit cards, but checking accounts, as a single product, seems to me overlooks the whole idea of the relationship a bank has with its customers.

SCHMALENSEE: Let me react to that before you go to the next question, because I think that raises an important set of issues. You’re absolutely right. You’re absolutely right. One of the reasons high balance accounts have been free checking for a fairly long time is that these are the customers the bank wants. And first of all, they make money loaning out the balance in your account, right? That’s the traditional banking model. You keep a balance in your account, that gets loaned out at a higher rate. That’s an important source of revenue. And maybe they can persuade you to buy other products.

The equation changes, however, when you take – when you reduce debit card fees, because it changes the attractiveness of different customers. All of a sudden, a low balance customer is less attractive. There are still costs. Every bank has costs associated with the account. The question is, who do you want? Who do you want as a customer?

If I carry a low balance but do a lot of debit card transactions, I could be an attractive customer. I may or may not take out a mortgage, but you know, all else equal, I am made less attractive. I’m made less attractive if that debit card revenue goes away. Am I worth something? Yeah. Am I worth the cost of maintaining my account? Maybe not.

So I put a fee on. I put a $5 a month fee. All right? So that says, if you cover the $5 a month fee, you probably have a high enough balance that I’m interested in you for my long-term relationship. If you can’t pay a $5 a month fee, and you carry a very low balance, what are the odds that you’re going to take out a mortgage, or a business loan? Probably low.

Again, I’m not a banker. You’re absolutely right that I want a checking account customer for the relationship, but not all checking account customers are created equal. The rise of free checking during the last decade wasn’t charity. It wasn’t charity. It was, oh, wait, these customers are profitable now. All rolled in, taking into account interchange, the prospect of a loan, the prospect of buying other products – all else equal, I want these people. Now they’re less attractive. That’s the change. They’re less attractive.

PALMER: My short question is this. You’ve indicated that banking, in your opinion, is a very competitive industry. You didn’t say anything about how competitive the retail industry is. I think we have to say it’s exceedingly competitive. But the banking – let me go back to the banking industry.

The banking industry is very competitive, but you say that the banks will raise their rates on various checking accounts. It doesn’t seem to take into account the fact that with a great deal of competition, you can’t just raise your rates. As a matter of fact, one of the big banks – perhaps this forces the idea that there is competition – has said that they won’t. Wells Fargo quite clearly said that, that they would not raise their checking account fees as a result of this if it happened.

And secondly, Wells Fargo said – and you talk about a Home Depot making a very – your characterization, a very telling remark, Home Depot – rather, Wells Fargo said to their investment community, that we’re not going to be terribly affected by this Durbin interchange. We’re going to remain very profitable, and we’re going to continue to focus on customers and the relationship. Thank you.

SCHMALENSEE: Wells is taking a particular strategic move. Other banks, as I showed, are going the other direction. It’s an interesting move by Wells. And I did address competition in the retail sector, and I think there’s plenty of evidence that says that in some important retail sectors, competition is a good deal less intense than it is in retail banking, in most metropolitan areas.

EVANS: Dick, thanks a lot.