Durbin, Debit, and Financial Reform

The U.S. Congress is in the final stretches of passing financial reform legislation which has been under intense discussion and debate since the implosion of the financial system in September 2008. Congress is now trying to reconcile the Senate bill spearheaded by Senator Dodd and the House bill shepherded by Congressman Barney Frank. Financial reform was one of the most important topics that Congress has had to deal with. The housing bubble that burst in the latter part of the decade revealed enormous problems in financial regulation in the United States and other countries. Whether those problems actually caused the crisis, or made a bad situation worse, is a subject that will be debated for a long time. The unfortunate reality is that there was a mass delusion that housing prices would just keep going up forever, untethered to realities such as supply and demand, and it is just hard to know whether any regulator would have done anything about it. Nevertheless, when the bubble burst, it became apparent that there were a lot of aspects about the financial services industry, and how it is regulated, that needed fixing.

At first it seemed as if, in the wake of a crisis that could well have sent the economy into a very deep and long lasting depression, politicians would really roll up their sleeves and take fixing the problems seriously. In my experience working with Congress last year, they did. They were anxious to understand what happened and to fix it. Then, perhaps because it became apparent that the economy wasn’t going to sink into the dark ages, politics got in the way. As I’ve written before, Congress and the President dropped the ball. They ducked many of the serious problems with regulation and instead focused on pet projects that had little if anything to do with reducing the likelihood we would have another serious financial crisis or getting the economy moving again. Perhaps most unfortunately Congress has settled on legislation that is the worst of all possible worlds: it doesn’t fix some of the most serious problems that needed to be dealt and creates impediments for getting people back to work.

The Durbin Amendment is emblematic of the abject failure of Congress and the President to do the right thing. It would require the Federal Reserve Board to regulate the setting of debit card interchange fees so that they are “reasonable and proportional to processing costs”. It would allow merchants who take debit cards to impose surcharges or dollar limits on transactions, basically overriding the contracts that are now in place with the card networks. One doesn’t have to wade very far into the heated interchange debate to recognize just how bizarre this amendment is. If there is one financial services product that no one has argued, or could possibly claim was at the heart of the financial crisis, it is the debit card.

Up until the mid 1990s virtually all card transactions in the United States were made with credit cards. There’s been a lot of concern that credit cards have enticed Americans to get overextended and even to go into bankruptcy. I think those concerns are overstated as I have written in my article with Josh Wright on consumer financial protection but it is certainly true that easy credit, like cheap beer, has gotten some people to act irresponsibly. Banks could have issued debit cards since the early 1970s (the product was available) but didn’t find it in their economic interest to do so. The card networks got behind the debit card in the mid 1990s, merchants embraced it, and debit cards grew explosively. Of course when consumers use a debit card the money comes right from their bank account and they have no risk of being lured into borrowing. The debit card is to the credit card what sparkling water is to beer. In fact, many consumers use their debit cards as a way to prevent themselves from borrowing for certain things like the staples of life. From the standpoint of consumers I believe one can make a fair case that the debit card is one of the greatest financial innovations of the last quarter century.

The debit card had nothing whatsoever to do with the financial crisis and one would have to be quite out of touch with reality to even suggest that it did. Unfortunately, Congress and the President have used the financial crisis as an excuse to pursue policy objectives that have nothing to do with the financial crisis while at the same time avoiding many of the issues that did. As I argued in this piece, politics got in the way of dealing with the one major reform the country really needed—consolidating banking regulation, eliminating the ability of those that are regulated to in essence pick their regulator, and eliminating the incentive for regulators to shop themselves around to their potential subjects. It remains to be seen whether the final bill will deal with the other Alice-in-Wonderland world—the rating agencies that prosper under a government umbrella that discourages competition and encourages biased ratings.

Unfortunately, the Durbin amendment isn’t just one of those earmarks that Congresspeople stick in to get votes back home. It isn’t the bridge to nowhere. Those paybacks cost taxpayers money but don’t impose much long term harm on the economy. The debit interchange fee amendment is a different matter. It starts this country down the road of imposing price regulation on the payments industry and will inevitably lead to other government intrusion into the products and services provided by payments industry. This is not only misguided but a colossal mistake.

Society has reaped massive benefits from largely unfettered competition in payments. Payments was, once upon a time, something that was mainly run by the U.S. government. The Feds printed cash and at least from the early part of the 20th century were largely responsible for the checking system. Little innovation occurred and the U.S. got locked into an inefficient paper-based payment system. The successive introduction of the credit card, debit card, and prepaid card—by the private sector– has lowered the cost of exchanging value—and the transactions costs of providing ancillary services like credit—considerably. Merchants and consumers have all benefited from this. The payments industry needs to make that case more effectively, and so far has done a pretty poor job at it.

The consequences of the Durbin amendment are pretty easy to forecast sadly enough. Someone obviously needs to pay for the debit card system. There is no evidence that I know of that it is a massive generator of profits for anyone so price caps aren’t going to come out of profits. Regulations if they are put into place will simply shift the cost of the debit card system from the retailers to the consumers. At least in the near term the retailers will pocket a good portion of that money in the form of extra profits. Consumers shouldn’t expect to see price reductions. Banks are going to have to figure out how to recover the costs of offering debit cards and it is inevitable consumers will face higher banking fees in one form or another. It is also likely that banks will be less enthusiastic about debit cards and regain for love for the plain old paper check. But I actually think these are small potatoes relative to what the real cost of the Durbin Amendment will be. The most serious cost is that we may have the Federal Reserve Board—the entity perhaps most responsible for the United States being awash in paper checks—with its thumb on the pace and direction of innovation in the payments industry. The value that consumers and merchants could lose from that during the 21st century could be gigantic.