– Download the Interchange Fee Proposed Rule Draft Notice
– Download the Interchange Fee Proposed Rule Staff Memo
– Watch PYMNTS.com Durbin Webinar: Analysis of the Fed’s Draft Debit Card Regulation
DAVID S. EVANS: Good afternoon, everyone. Yesterday, the Federal Reserve Board staff presented their proposals for regulating debit card interchange fees to the Board and the Board voted to release the proposals for public comment. We’re going to discuss the proposals today with several economic and legal experts who’ve been following how the Federal Reserve is going about implementing the so-called Durbin Amendment, which is Section 1075 of the Dodd-Frank Act. We have Tim Attinger, who used to be the Head of Global Products and Innovation at Visa on the phone. Right above me is Tom Brown, who’s a partner O’Melveny & Myer and a legal advisor to various firms in the payments industry. To my left we have Tom Durkin, who used to a senior economist at the Federal Reserve Board. He’s also a leading expert on truth in lending regulation, with a book coming out on that topic in a couple of months. Right next to Tom Brown we have Ron Mann, who’s a law professor from Columbia University and the author of one of the leading casebooks on the payments industry. Guys, thanks a lot for joining me today.(Related Article: Debit Card Interchange Fees Plummet Under Fed’s Proposed Rules)
And this, by the way, is David Evans. I’m doing this for PYMNTS. com. So Tom, where did the Federal Reserve Board staff come out yesterday on what banks can collect in debit card interchange fees?
TOM BROWN: Well David, the Fed released its proposed rule implementing what we all think of as the Durbin Amendment to Dodd-Frank. It contains actually two proposals with respect to where interchange might come out, both of which involve a rate cap and a safe harbor. One proposes a cap at approximately 7 cents. The other proposes a cap at 12 cents.
EVANS: And what happened to the fraud adjustment?
BROWN: The Fed staff essentially punted with respect to the fraud adjustment, and for people who are not maybe intimately familiar with Dodd-Frank, the statutory language allowed the Fed to develop a standard that recognizes the statutory language provides for standards for setting interchange that are tied to incremental costs associated with particular transactions, recognizing that fraud prevention efforts might not be tied to particular transaction. The Fed was unable to develop a specific proposal but has floated the idea of a proposal somewhere in the 1 cent to 2 cents range – I believe the number was 1.9 cents – that will allow financial institutions to recoup approved fraud prevention measures. The Fed staff appeared worried that other proposals would essentially reward inefficient behavior with respect to fraud prevention. (Related Briefing Room: Security and Fraud)
EVANS: So let me just embellish your answer on the safe harbor and the cap just a little bit. So the 7 cents, just to remind people, is based on a calculation the Fed did of survey data that they got from issuers. The 7 cents was the median average variable cost of authorization clearing and settlement, and the 12 cents, which is the other cap, is the 80th percentile. In other words, 80 percent of the issuers, the Fed staff finds, had average variable costs of authorization, clearing and settlement of less than 12 cents.Now, one of the interesting things that I found in the Federal Register notice, is the Fed staff’s claim is that the volume – that when you take a volume-weighted average of the average variable costs – was only 4 cents. So were they being generous in going three times higher than that with the 12 cents?
BROWN: I think you’d have to ask an economist. So I think Tom Durkin, I’d be curious to get your reaction whether you think that issuers are celebrating the spread between 4. 5 cents and 12 cents per transaction.
TOM DURKIN: No, I don’t think they’re celebrating. Either the 7 cents or the 12 cents is lower than the current range. I think that it actually is surprising to me that the number is as low as it is, and I’m sure they’ll be checking the math on that. But apparently they have been quite careful. It looks like they have been, and so no, I think that nobody’s going to celebrate. Nobody in the payments industry is going to be celebrating that number
EVANS: Now, of course, I was being facetious on that. But Ron, let me turn it to you for a second. They also made a proposal on how many networks an issuer has to have on its debit cards. What did they say?
RON MANN: If we’re going to continue the football metaphors, they really punted on that one because they presented two proposals. Under one proposal, they’re going to be perfectly willing to let people have the cards that probably are most of the cards that people have right now, which is to say the signature product is either Visa or MasterCard, and the PIN debit product is somebody different. So the PIN debit product would be – I don’t want to advertise for any particular one – but STAR, NYCE or Pulse or even if you had a Visa signature, probably you could have the MasterCard PIN debit product. So that’s the proposal, which wouldn’t really require much change. The other proposal that I think would require more change, but which is I don’t think what people have feared, would require you to have two unrelated signature products and two unrelated debit products. So presumably, you’d have to have both MasterCard and Visa on each debit card and two debit products, one of which could be MasterCard or Visa, one of which would have to be somebody else. The staff memo seems to strongly favor the former because they think the second one would be impractical, but the actual regulation leaves that it’s two alternatives to be commented on.
EVANS: Just to toss out another number just so that we have it all firmly in mind, I did a quick calculation of the percent reduction in average debit card interchange fees. The 12 cents is roughly 80 percent lower than the current average of 56 cents for a signature debit, and it’s about 73 percent lower than the average of 44 cents that combines PIN and signature. So, as Tom Durkin pointed out, this really is a significant reduction in debit card interchange fees. So what surprised you the most about what the Federal Reserve staff presented to the Board of Governors yesterday, or maybe didn’t present to the Board of Governors yesterday? And I’d like to start this out with Tim Attinger. (Related Article:Dodd-Frank Chief Author Opposed to Feds Initial Debit Proposal)
TIM ATTINGER: I’ve got to agree with Tom and Ron. It was very much a ground control game of football yesterday of punts all around. There was a punt on the network exclusivity, essentially two options presented but no recommendation. A punt on network fees and issuer cost and a punt on fraud.
DURKIN: I think that at yesterday’s meeting, there were some things that were not surprising, and then what they need to in each of those areas, I think that there were some aspects that were surprising. For instance, I think the basic approach to a reasonable standard was something we’ve understood for a long time. In other words, it was to be cost-based. It was based on their questionnaire that they circulated some months ago, so it’s been available for everybody to look at how they were approaching this. But I think what was surprising was the outcome, that it was as strict as it was. It did not include some costs that I think arguably could have been included and that none of the ones that were – not the strict interpretation – were included in their calculation. So, I think that was a little bit surprising. As I mentioned before, I think the overall outcome that the cost was as low was a bit surprising to me. Maybe people who actually function in the industry and know this a bit better, but it’s surprising to an economist, I think, to see the market behaving this way. But in another area I think that was not surprising was that they did suggest a range of outcomes in various areas, and that’s a typical way for the Fed to do things. But in this case, it seemed like they did not tip what their thinking really is, whereas usually a range will be much narrower than it was this time. This time, the only thing that was narrow was the pricing range, but as already been mentioned, things like that exclusivity had the polar extremes for the alternatives, and fraud adjustment, they didn’t announce what they’re going to do at all, in a sense. And so the basic approach wasn’t surprising, but the details were very surprising, I think.
EVANS: Tom Brown, were you surprised, and if so, what surprised you?
BROWN: Two things surprised me. One, an aspect of the proposal and then second, an impression. Before sort of getting into the particulars, it reminds me to make the necessary disclaimer that I’m here speaking entirely on my own behalf and not on behalf of anybody that I may have worked for or continue to represent in the industries affected by the regulatory proposal. So with that, I was surprised that the Fed staff recommendation included a cap. The statutory language does not actually demand or even suggest that that would have been the outcome of the Fed’s regulatory proposal. The statutory language directs the Fed to produce a set of standards by which reasonable interchange rates will be set. I think an argument can be made that the proposed rate cap stretches the statutory mandate beyond the permissible grounds that an agency can interpret as statutory mandate. So that was one thing that was surprising to me as a legal matter.
The second was sort of impressionistic. So that is, sitting in my office watching the Fed staff recount how they came to their resolution, I was stunned that they appeared to universally have concluded that the set of arrangements that connect financial institutions, merchants, networks and consumers and drive the exchange of value in this industry are so dysfunctional as to require was really an extraordinary intervention on behalf of the government – that is, rate caps and sort of mandatory dual sourcing with respect to network arrangements. And that really did surprise me, considering that it’s the Federal Reserve, which we typically associate with protection of markets and think of as a relatively free market institution. And so I was surprised by that. (Related Briefing Room: Dealing with Durbin)
EVANS: And it was also the question by Chairman Bernanke concerning whether there was a market failure. And he got a very specific answer from the Fed staff on, yes indeed, Chairman, there is a market failure here and this is what it is. So they seem to be at least buying into the notion that there’s a problem here.
BROWN: Yeah, and I think it’s worth talking about that response, because you and I both heard it and had, I think, pretty much the same reaction, which is Chairman Bernanke asked the question and the asserted market failure was, well you know Chairman, in competitive markets, more competition means prices go lower, and that doesn’t appear to be how this market functioned. So therefore, we need to regulate to the competitive outcome. I believe that I once learned from an economist that increased competition with respect to scarce factors does not lead prices of those factors to go down. I was just surprised that that point was apparently missed by Fed staff in preparing for their response.
MANN: I mean, the reason that the prices are different – the prices go up and down – has much more to do with the differing marginal elasticities of demand between cardholders and merchants. That’s why interchange fees are higher here than they are in other countries, because penetration in the market is higher. (Related Article:Durbin Down Under)
EVANS: So Ron, if you could continue on that and tell us what surprised you.
MANN: Well, really, lots. I agree with everything that Tom and Tom said, and so I’ll pick something different. In speaking as more of a lawyer, the thing that surprised me most is reading their explanation of how the use of statutory language, the incremental cost is the same as the average variable cost.
EVANS: Ron. I’d like to get your reaction to this. What I found interesting was that there were a lot of places where they said, our hands are tied, this is what the legislation says, we have to do exactly what it says, we don’t have any discretion on this. And then, there are places where they seem to be very happy to simply ignore it and do what they wanted to.
MANN: I think you got that exact, second flavor with respect to the network exclusivity, and the staff basically concluded, well if we said they have to have two signature networks and two PIN networks in every card, that would be impractical. That would require people to change the way they do things, as if cutting the rate from 56 cents to 12 cents isn’t going to require some changes. But I’m the one who – last time we had one of these webinars, I said – I assumed they’re going to try really hard to come up with a rate that’s high enough to not seem confiscatory. From listening to what Tom Durkin said, my impression of what they did is they viewed cost, the economic data in the most jaundiced possible way, but then claimed that they’d adopted the most issuer-favor economic standard that you could imagine. It’s a very strange product, because I don’t think it should make anybody satisfied.
EVANS: Let’s turn now to Tom Durkin. Tom, the legislation says interchange fees are supposed to be based on incremental cost, reasonable and proportional. The incremental cost, I guess, is one interpretation of it. The staff decided to base its proposed safe harbor and the ceilings on the cap, on the average average variable cost of authorization, clearing and settlement. So how did they go about calculating the average variable cost if you know?
DURKIN: What we know from looking at their questionnaire, and you can see the kind of cost information that they gathered, and simply then they ran an average. They took a bunch of costs and added them up and then divided that by the volume. What seemed to me to be surprising was that they could have, I think, included a few more costs, but they didn’t. If you look at the questionnaire, they included all the costs in III, and they didn’t include any of the cost in IV. And I thought that they were going to include at least some of those. Arguably, an allocation of costs, for instance, for production and distribution of the cards, is part of – arguably, it’s part of an incremental cost that you – an allocation of what has to be part of the cost of running this business, and so do costs for, for instance, running a call center. Regulation already requires, for instance, that they have error resolution procedures in place. And to have error resolution procedures in place, generally speaking you have to have a call center, and those are immensely expensive, require a lot of people and communications lines, things like that. Not to allocate any of the cost of those to the individual transaction seem to me to be a bit surprising.
EVANS: Let me continue on that just for a second, Tom. So you’re an economist and you’re at the Fed. What do you make of the statement by the staff that incremental cost has too many definitions, and they really didn’t know how to implement an incremental cost standard, which is what the statute actually says they’re supposed to do?
DURKIN: Oh, I can hypothesize a little bit about that, and I don’t think of that as a practical matter, as too important for this individual situation because I think what they were really relying on. Of course, this is me speaking. This isn’t their thoughts, because I don’t know exactly what their thoughts are. But it seems to me that they realize or they believe that marginal cost and average cost in the size range of institution they’re talking about – in other words we’re not talking about a whole range here of sizes. We’re talking about only very large institutions, those over $10 billion. And they know for technical reasons and past studies and so forth that the average cost and the marginal cost are going to be quite close in that size range. And so therefore, doing the thing that’s the simplest, collecting the average cost information, is going to solve the problem for them. And I expect that eventually, they will try with scientific papers, to prove through mathematical models and things that average cost and the marginal cost are very close in this range. But I think they believe that. I think they’re probably right. And so that approach is probably not a bad approach. It’s much simpler to do in a reasonable length of time.
EVANS: Tim, the Board of Governors wasn’t really pushing back on the general trust of the recommendations. I don’t know if you had a chance to listen to them. That’s going to result in about an 80 percent to 90 percent decrease in signature debit card interchange fees, depending upon whether you go with the 7 cents cap, in effect, or the 12 cents cap. If those reductions go into place, what are banks going to do in reaction to that?
ATTINGER: I think it is probably not surprising to see the Fed come out with a simple number and ask to be at a very low number, and one you can calculate fairly easily, given the way the original legislation was framed, the accelerated timeframe that the Fed was given to come up with these numbers, and the fact that the rest of those allocations of costs of managing a deposit account and looking at a debit card as a relationship vehicle. The underpinning of the relationship with the deposit institution for the consumer has now essentially become a really low-function transaction vehicle against that deposit account.
I think in that context, to keep the P&Ls going completely upside-down against national institutions and still provide deposit services to consumers, financial institutions are really going to be looking at, how do I innovate on top of what is still a great vehicle for managing transactions from consumers at the point of sale and still could be the underpinning of this relationship? But the financial picture of my deposit account is no longer supported by this primary relationship vehicle. So I need to add other services to it – hopefully fee-bearing services. I think we’ll see quite a bit more investment in getting merchants engaged in driving loyalty offerings to consumers as a way to drive more value to the financial institution and more value to the consumer and get the merchants engaged in the delivery of that reward. (Related Briefing Room:Loyalty and Rewards)
I think we’ll see more remote delivery of services because call center costs, as Tom just mentioned, were either ignored or put to the side. You still have to service customers, so I think we’ll see mobile alerts and mobile notifications. Mobile banking will expand much more dramatically. I think we’ll see much more online banking penetration as financial institutions try to find a way to still sell and service consumers in the context of what has been just a massive hit to what was the core relationship vehicle of those accounts. (Related Briefing Room:Mobile Payment Apps)
EVANS: Tom, from the standpoint of the issuers and the networks, there’s an enormous difference between two is enough to four is enough, those being the two proposals that they came out with. What issues does that raise, and how do you see it being resolved, and do you agree with Ron that the Fed seems to be leaning towards the first proposal, just an unaffiliated PIN network in addition to the signature network? What do you think?
BROWN: There are obviously many issues raised by the exclusivity and routing previsions of the Durbin Amendment. The most obvious, at least from a legal perspective, are the constitutional issues, I think, that are raised. Even on the two is enough proposal, but certainly when you start expanding the number of networks with whom any financial institution is obligated to contract, as I sort of alluded before, government-mandated sort of multiple sourcing arrangements are not a common form of intervention in a functioning economy. And there is a confiscatory dimension to either the two, but certainly compounded in the four proposal, that I think raise significant issues. Obviously there are major operational issues associated with implementing either the two is enough or the four is enough proposal. And one, I guess – sort of circling back to an observation made earlier – I think staff has done an amazing job of compiling information and generating a proposal in a relatively short period of time, given what they perceive the statutory mandate to be.
I think it’s odd from a policy standpoint, and maybe this is something that needs to be directed at the language, but one constituent whose interests – certainly with respect to network routing and exclusivity – don’t appear to be on anybody’s mind are consumers. When you start getting to the four is enough proposal, you sort of wonder, is it really the case that the consumer should have no say whatsoever in how the money from their bank account gets routed to the merchant? This seems like a surprising result, particularly when we know that there are significant differences across networks and when we have – whether we know it as an empirical matter, we should have a very strong intuition that the introduction of additional networks at the card level creates significant new opportunities for fraud because of the loss of the capture of the data for the wide volume of transaction. So there are all kinds of issues that are sort of embedded in the exclusivity and routing provision that, at least at this point, don’t appear to have been explored in the compressed time period available to the Fed staff – I think for entirely legitimate reasons. They’ve done an enormous amount of work in a short period of time, but before these proposals are implemented, I think people should take a hard look at what the consequences would be particularly on the routing and exclusivity issues.
EVANS: So words like confiscatory and constitutional provide a good segue to the next question, which is for Ron Mann. Ron, we’ve talked before about whether the Durbin Amendment is a jobs act for lawyers. Will the Fed proposal settle things, or are we looking for years bickering in court?
MANN: I think it doesn’t settle things. I think it settles relatively little, except it sets up the next stage of litigation. You can’t do much to challenge the statute that’s supposed to be implemented by litigation – by regulation until you see what the regulations are. And so the case that TCF Bank has brought is a lot crisper now.
I think that the suggestions that Tom Brown has just made, if the Fed goes with the four is enough, much less – if they go with the four is enough proposal, I think you could be sure there’ll be litigation about that. And I think that the fraud provisions pose a problem, too. I take it that the regulation goes into effect and you can’t charge anything for fraud prevention, what – I don’t know about that, and I think there’s obviously some argument that issuers might take advantage of to suggest that there’s no statutory basis for a cap. If you have somebody who can prove, and I take it that even under the most narrow – narrowest possible view of cost that 20 percent of the issues could document, to the satisfaction of a harsh critic, that their costs are more than 12 cents, I think if their costs are plainly more than 12 cents, it’s a reasonable proportion for them to charge 15, and the regulation doesn’t permit that. And so I think you can expect a challenge from that front. So I don’t think this is going to make anybody happy. You suggested in some discussions yesterday that maybe it makes the merchants happy, but I think even the merchants had some hope from the statute, they’re going to clearance at par, talks about comparing it to checks.
PYMNTS.com “Deep Dive Into Durbin” Speaker and Moderator Bios
Tim Attinger/Managing Director: Product development and innovation expert
As the former head of Global Head of Product Innovation and Development for Visa Inc., Tim had global responsibility for product strategy, platform development, and P&L management for Visa’s mobile, money transfer, and eCommerce business units, as well as product innovation, security solutions, healthcare and IP strategy. In this role he led a number of innovation efforts related to debit cards.
Tom Brown/Senior Expert: Partner at O’Melveny & Myers
Tom Brown is a partner in O’Melveny’s San Francisco office and a member of the Financial Services Practice. Tom’s practice focuses on competition law and legal issues affecting the financial services industry. Tom has been litigating cases, including class actions, in the financial services industry for more than a decade. He was a member of the trial team that handled the defense of the then largest civil antitrust class action in U.S. history for Visa U.S.A. Inc., In re Visa Check/MasterMoney Antitrust Litigation. He has helped numerous other financial services companies, including Capital One and PayPal, defend against class actions, including an ongoing case challenging the use of PayPal in the eBay marketplace.
Tom Durkin/Senior Expert: Economist and former Federal Reserve Board director
Tom was a Senior Economist at the Federal Reserve Board for more than 20 years and was the Regulatory Planning and Review Director for ten. As a result of this experience, he is deeply knowledgeable about how the Federal Reserve Board approaches regulation. He has also written extensively on consumer credit and its regulation. His most recent book, Truth in Lending, Theory, History, and a Way Forward, will be published by Oxford University Press in the Fall of 2010.
Ron Mann/Senior Expert: Law professor and business advisor to the payments industry
Ron is one of the leading global authorities on the law and economics of payments. He has authored numerous authoritative books and articles on the law of payments including Payments Systems and Other Financial Transactions. He is a Professor of Law at Columbia University.
David S. Evans/Founder and Managing Director: Economist and business advisor to the payments industry
David is one of the leading global authorities on interchange fees and financial regulations. His recent work has focused on helping payments businesses discover and ignite profitable innovation. He is the co-author of the leading text on the payments industry, Paying with Plastic: The Digital Revolution in Buying and Borrowing, as well as leading texts on driving innovation in two-sided markets including Catalyst Code: The Strategies Behind the World’s Most Dynamic Companies and Invisible Engines: How Software Platforms Drive Innovation and Transform Industries.
Debit Card Interchange Fees Plummet Under Fed’s Proposed Rules
Dealing with Durbin Briefing Room
NRF Says Federal Reserve Action on Debit Cards Could Lead to Discounts for Consumers
Federal Reserve Regulations Would Harm Consumers, Provide Windfall to Large Merchants
First Data Responds to Federal Reserve Board’s Proposed Rules
We’re always on the lookout for opportunities to partner with innovators and disruptors.
Learn More