Economic Principles for Interchange Fee Regulation
by David S. Evans, Robert E. Litan, Richard Schmalensee[*]
February 22, 2011
(Executive Summary of Comment Submitted to the Federal Reserve Board Regarding the Implementation of the Durbin Amendment)
Over the last century economists have developed a three-step process that regulators should follow for designing rules that are in the public interest. The regulator should determine whether there is a market failure; design the best feasible remedy for that failure; and ensure that imposing the remedy will improve social welfare after considering known costs and possible unintended consequences. Applying this framework to Board's December 16, 2010 proposal we four each main conclusions.
(1) The Board has not conducted a proper diagnosis of the problem that its rules should fix. The proposals that the Board has issued for comment are not based on a proper diagnosis of the problem to be fixed. Only by properly diagnosing the problem could the Board ascertain whether the proposed rules are "reasonable" under Section 904 of the Electronic Fund Transfer Act. Debit cards have improved the efficiency of the payment system by displacing checks, as officials of the Federal Reserve System have recognized on numerous occasions. They have become the most popular non-cash form of payment and are preferred by consumers over alternative forms of payments, especially checks. Consumers report that debit cards are more often accepted by merchants than checks according to the Federal Reserve's 2008 Survey of Consumer Payment Choice. There is no evidence that debit cards are overused. The fact that merchants pay much of the cost of debit card transactions just means that debit is similar to other two-sided markets in which merchants participate, including shopping malls and advertising on search engines, social networks, and traditional media. The Board has not identified a market failure that its proposals could correct.
(2) The Board has chosen an approach for regulating debit card interchange fees that its staff and other economicsts have concluded is the wrong approach. The proposals that the Board has issued for comment employ remedies that the Board staff itself has found to have no support in economics. Summarizing the consensus in the economics literature the Board staff has found that "economic theory underlying the efficient interchange fee provides no rationale for ... a strictly cost-based interchange fee." The economics literature is virtually unanimous on this point. As a general matter, adopting the wrong regulatory solution to a problem that is not well defined is likely to make consumers worse off. The proposal to base regulation on cost alone in this case is like a physician, unsure of the right diagnosis, nonetheless prescribing a remedy that the medical literature agrees is inappropriate for any plausible illness considered.
(3) The Board's proposal interchange fee regulations would harm the public. The Board staff has found that it is "hard to anticipate" whether consumers will be better or worse off. Our analysis finds consumers are likely to be substantially harmed on balance by the proposed regulation, because the higher costs they would face on their checking accounts would likely exceed any price reductions they would receive from merchants, at least over the first 24 months of the regulation. We also find that lower-income households and small businesses would be harmed if the proposed regulations were implemented. The Board's proposal violates the cardinal rule of regulation: "do no harm."
(4) The Board should withdraw its proposal and ensure that any new proposal would not harm consumers. The proposed regulations that the Board issued for comment should be withdrawn and significantly revised, and the Board should ensure that any future proposals meet the tests of either not harming consumers or demonstrating some other efficiency that could outweigh the costs to consumers of the regulations. Until the Board conducts the necessary empirical research to estimate socially optimal interchange fees, the Board should find that market-set interchange fees are "reasonable and proportional to cost." Market-set rates would cause less harm to consumers and other parties in the economy than the interchange fee cap and safe harbor in the draft rule issued for comment by the Board. Market-set rates are no less reasonable and proportional to costs, especially given the wide variation in costs among banks found by the Board. Our research finds that the market-set interchange fee is likely to be close to the socially efficient fee. The Board should err on the side of caution before adopting rules that harm consumers, especially lower-income ones, and harm small businesses.
[*] Evans is Lecturer, University of Chicago Law School and Executive Director, Jevons Institute for Competition Law and Economics, and Visiting Professor, University College London; Litan is Vice President for Research and Policy at the Kauffman Foundation and a Senior Fellow in Economic Studies at Brookings; Schmalensee is Howard W. Johnson Professor of Economics and Management and Dean Emeritus, MIT Sloan School of Management. We received financial support from several large members of the Electronic Payments Coalition; these institutions also provided information and data and were given the opportunity to provide comments on this paper. The full paper is available on SSRN by clicking Economic Principles for Interchange Fee Regulation.
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