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This article examines how the Federal Reserve Board’s proposed implementation of the Durbin Amendment will affect consumers and small businesses. A main objective of the Dodd-Frank Act was to protect consumers. Moreover, the debit card regulations are part of the Electronic Fund Transfer Act, which requires the Board to consider the impact of regulations on consumers. Small businesses were often invoked as one of the main beneficiaries of the Durbin Amendment. According to Senator Durbin, “Small businesses and their customers will be able to keep more of their own money. Making sure small businesses can grow and prosper is vital to putting our country back on solid economic footing.”  This article shows that surprisingly consumers and small businesses would both lose significantly from the proposed rules.
The Federal Reserve Board offered two proposals. The 12-cent price cap proposal would permit debit card issuers to receive 12 cents per transaction. The 7-cent safe harbor proposal would permit debit card issuers to receive at least 7 cents in interchange fees per transaction and up to 12 cents if they could show that their average variable costs for authorization, clearing and settlement is greater than 7 cents. The 12-cent cap would wipe out 73 percent of the debit card interchange fee revenue that banks receive currently, and the 7-cent safe harbor would eliminate 84 percent. Banks and credit unions would receive an estimated $33.4-$38.6 billion less revenue than they would have received under current rates in the 24 months  after the caps go into effect. (They are scheduled to do so on July 21, 2011.) The reductions in debit card interchange fees would, in the absence of efforts by banks to mitigate the losses, reduce demand deposit account (DDA) specific revenues by between 21 and 24 percent and would reduce the revenues from retail banking by between 7 and 9 percent. 
Therefore, banks would take an enormous hit and would need to do something. Based on past experience and what banks are saying, they would quickly increase checking account fees and possibly debit card fees to make up for the losses and would cut back on services to save money. Also, given that retail banking is a highly competitive industry, we know from basic economics that the banks and credit unions would probably pass on most of the lost revenue in the form of higher fees and reduced services.
That is not the end of the story, though. Merchant acquirers would have an equal and opposite decrease in their expenses. They would not have to pay debit card issuers $33.4-$38.6 billion in the 24 months after the limits go into effect. Large merchants would get an immediate saving because their merchant processors generally have to pass on interchange fee savings fully under interchange-fee plus contracts. These savings would amount to about 10 cents on a typical $60 purchase. A number of economic studies have shown that businesses do not change prices quickly or often when faced with small increases or decreases in cost. Moreover, many of the merchant categories benefiting from the interchange fee reductions are not the intensely competitive industries that would likely pass on the savings in full to consumers.
In fact, small merchants may not see much savings initially. They generally have signed blended contracts that set a single discount rate for all payment cards, and merchant processors have less motivation to pass on cost savings quickly or fully to these smaller businesses. Since these small merchants may not see much savings, their customers are even less likely to see savings than customers of the larger merchants.
With this basic background we can tote up the benefits and costs for consumers and small businesses. The roughly 180 million American consumer checking accounts would face higher fees as banks recover lost revenues by increasing fees or reducing services. Consumers might eventually get some savings when they buy goods and services, but merchants who get lower debit interchange fees are unlikely to pass on the savings quickly or in full. On net, consumers would be out of pocket tens of billions of dollars in the first 24 months of the proposed regulations. Lower income households will be especially hard hit by increases in account service fees. Many of these households were able to open bank accounts over the last decade as a result of the rise of free checking. With those bank accounts, low-income consumers received debit cards, which enabled them to pay electronically. As a result of higher fees, many would drop these accounts and lose their only general-purpose payment card. It is hard to predict from available data what the net effect would be, but it is plausible that the Fed’s proposals would result in at least 1 million more unbanked households.
Small businesses, perhaps surprisingly, would be losers as well. About 15 million small businesses have checking accounts. Their fees would go up as banks recover the lost debit card interchange fee revenues. Small businesses could pay upwards of $4.2-$4.8 billion in higher checking account fees and reduced services in the first 24 months following implementation of the proposed regulations. Most small businesses do not accept debit cards for payment and therefore would not see any offsetting savings. But even the small businesses that do accept debit cards may not see much of a benefit. As noted above, they have blended pricing contracts with their merchant processors, and, as analysts are anticipating, it is unlikely that those processors would pass on the savings quickly and fully. (These contracts charge a single price across all different types of card payments and do not break out interchange fees separately.) On net, small businesses would also end up losing from the Federal Reserve Board’s proposed rules.
How Changes in Costs and Revenues Get Passed On to Consumers
To figure out how the revenue losses to banks and expense reductions to merchants would affect consumers, we can rely on a number of studies that economists have done over the years. These studies assess the extent to which changes in costs lead firms and industries to change the prices they charge.
When firms in an industry face an increase in variable cost, they will fully pass on that increase in the form of higher prices if the industry is highly competitive. For example, if the government imposed a $1 tax per unit of output, then we would expect firms in a highly competitive industry would increase prices by about $1 per unit. Competitive firms have to pass on cost increases because they would not be able to cover their costs otherwise, and they have to pass on cost decreases because their competitors or new entrants will lower prices to increase sales.
The effect of a change in cost on prices is much harder to predict when industries are not intensely competitive. In these cases there is no presumption that a $1 decrease in cost would result in a $1 decrease in price. Several empirical studies have found that in the particular situations examined firms eventually pass through between 40 and 70 percent of cost increases in the form of higher prices. The likely rate of pass through depends very much on the specifics of the business and the industry.
Studies have found that prices do not change very quickly due to small changes in costs. Firms tend not to change prices very often for a variety of reasons including the fact that it is expensive and time consuming to change prices. Therefore, prices tend to be sticky over a period of about a year on average. Price changes are especially unlikely when the optimal changes in prices are small, so the gains from changing prices are small relative to the costs of implementing the changes.
How the Fed’s Proposed Rules Would Affect Checking Account Fees
Retail banking is highly competitive. There were 7,760 commercial banks and 7,402 credit unions in the United States as of September 30, 2010. As a result of the end of interstate banking and branch banking laws, banks are now legally able to expand and compete anywhere in the country. When it comes to depository and other retail banking services, the day-to-day competition among banks and credit unions takes place in local areas. In the Georgetown section of Washington, D.C. alone, people could walk into branches for 13 different banks and set up a checking account. Based on a commonly used measure of the intensity of competition, retail banking is highly competitive in most major metropolitan areas and “urban market concentration has remained virtually unchanged” despite the national-level consolidations over the last decade. 
Not surprisingly, when banks started earning significant revenues from debit cards in the last decade, as the use of these cards exploded, they were forced by competition to pass back much of the gains to consumers in the form of lower fees and better service. Over the decade, debit card interchange fee revenues increased dramatically-not because the interchange fee rates went up but because the volume of transactions increased-and banks also earned significant revenues from overdraft fees associated with the use of these cards.
Perhaps the most striking related development in that decade was that “free checking” became almost ubiquitous. The percentage of accounts at large banks that qualified for free checking increased from 7.5 percent in 2001 to 76 percent in 2009. Figure 1 shows the growth of free checking and the use of debit cards over the decade. This figure does not demonstrate that there was a cause and effect relationship between the growth of free checking and the growth of debit card revenues. While other factors no doubt mattered, it is likely that the increase in debit card revenues was a driver of the expansion of free checking, since it made checking accounts more profitable to banks, all else equal.
Over this same period banks also increased the number of branches and ATMs and made online banking and online bill payment available for free. Banks and credit unions also reduced fees for using debit cards, introduced reward programs, and made it possible for consumers to get cash back at the point of sale for no extra charges. As consumers switched from checks to debit cards they also received fraud protection.
Recent changes in Regulation E concerning overdraft fees show how banks respond to significant reductions in revenues and how quickly they do so. Starting within days after the new rules went into effect, banks began to announce changes to address the expected loss of revenues by reducing the availability of free checking, raising other fees and eliminating services. By the fall of 2010, just a few months after the regulatory changes went into effect, most major banks had made significant changes. The percentage of accounts with free checking dropped 11 percentage points from 76 percent in 2009 to 65 percent in 2010. In the space of a year there were roughly 20 million fewer free checking accounts.
In the two months since the Federal Reserve Board announced its proposed reductions, banks and credit unions have reportedly been considering increased monthly maintenance fees on DDAs; transaction fees for debit card usage; annual fees for debit cards ranging from $25-$30 per year; fees for cash back at the point of sale; lower interest rates on funds in DDAs; limits to number of debit card transactions; limits to the dollar amount of debit card transactions; increases to ATM fees for non-customers; reduction or elimination of debit card reward programs, including savings programs; and increased balance requirements.
Banks and credit unions would decide which of these changes to implement in the marketplace based on competitive dynamics and market research on the response of consumers to alternative packages of changes. While it is difficult to forecast precisely how banks will increase rates, it is apparent that they will do so in response to the massive reductions in debit card interchange fee revenues. As we showed above, those revenues drove the expansion of checking account and related debit card services to retail banking customers in the last decade. The proposed reduction of interchange fees would result in the curtailment of these services. There is already widespread agreement that the combination of the debit card interchange fee reductions and the Regulation E changes would drastically reduce the availability of free checking. Recent history also teaches us that the increase in fees would happen quickly, following the pattern that occurred when Regulation E changes reduced revenues.
Banks and credit unions would lose between $33.4 and $38.6 billion over the two years following the imposition of the Federal Reserve Board’s proposal. The fact that the retail banking industry is highly competitive indicates as a matter of economics that most of these lost revenues would be passed on to consumers in the form of higher prices and reduced services. The fact that the financial shock to the banks is large suggests that they would change fees quickly. The history of the banking industry in the last decade supports this view. The last decade saw a reduction in fees and expansion of services in response in part to the debit card interchange fee revenues that banks received. That process would simply reverse itself with the elimination of much of these revenues. Thus we would expect that consumers would end up losing a significant fraction of the $33.4-$38.6 billion by way of higher fees and reduced services over the 24 months following the imposition of the rate reductions.
Lower income households would be especially likely to be harmed as a result of the reduction in debit card interchange fees. The percentage of low income households with access to a payment card increased from 45 percent to 67 percent between 1995 and 2007 as shown in Figure 2. (Low income households are defined as those with an income that is less than 50 percent of the median household income.) Crucially, much of the increase resulted from debit cards. The percentage of households with a debit card increased from 7 percent to 47 percent. This increase occurred at least in part because of the spread of free checking in the last decade. According to The Wall Street Journal, reporting in June 2010, “[t]he offers of free checking without any minimum balance requirements attracted a new wave of low-income customers, who previously went to check-cashing stores.” 
The proposed debit-card interchange fee reductions can be expected to push a significant number of lower-income households out of the banking system and to thereby increase the number of unbanked households. The Wall Street Journal article above also notes that “[s]ome consumer advocates have warned that the elimination of free checking could drive some of those customers out of the banking system.” On JPMorgan Chase’s 4Q 2010 earning conference call, Jamie Dimon, the bank’s CEO, stated that the fee increases that would result from the proposed debit card interchange regulation would make banking services too expensive for as many as 5 percent of Chase’s customers.  If that 5 percent figure applied for banks and credit unions on average, and if 20 percent of those were low-income households, the number of unbanked households could increase by 1 million.
Merchant Prices and the Reduction in Debit Card Interchange Fees
Large merchants generally have interchange-fee plus pricing with their merchant processors. They would thus immediately get the benefit of the reduced interchange fees. Under the Federal Reserve Board’s proposals, debit card interchange fees would decline by 32 cents per transaction under the 12-cent price cap proposal or by roughly 37 cents per transaction under the 7-cent safe harbor proposal. To assess the impact of these changes, first consider how the changes would affect the cost of a typical transaction. We have estimated that the average purchase at merchants is $59.89 and that about 29.3 percent of transactions are made with a debit card. Using these figures we find that the average savings for a large merchant would be 10.8 cents for the average purchase (0.18 percent) based on the 7-cent safe harbor proposal or 9.4 cents for the average purchase (0.16 percent) based on the 12-cent cap proposal. That works out to 1.6-1.8 cents for a $10 item.
It is likely that these savings overstate the actual savings that merchants would realize. Banks and credit unions would likely reduce the supply of debit card services including some services such as one-day settlement that merchants currently benefit from. In addition, banks and credit unions would likely take actions that would result in consumers and small businesses using debit cards less and alternative forms of payment such as checks, credit cards and exempt prepaid cards more. Banks and credit unions might also raise the cost to consumers of withdrawing cash at the point of sale, which would reduce the use of cash, which merchants contend is low cost to them. Therefore, the actual savings is likely to be less than 0.16-0.18 percent of the transaction amount. (Merchants may, on the other hand, take steps to encourage the use of debit cards at the point of sale, which could offset the adverse changes discussed in this paragraph to some degree.)
A number of economic studies of “price stickiness” document that firms do not change prices often and tend not to change prices in response to small increases or decreases in costs. Retail prices tend to stay the same for about a year according to several of these studies. These studies make us doubt that merchants would quickly lower prices in response to the relatively small per-transaction cost savings they would realize under the Federal Reserve’s proposal.
Eventually though, prices do change and we would expect merchants to lower prices. But there is no presumption that merchants would pass on all or even most of the cost savings to consumers. We concluded that banks and credit unions would pass on much of the revenue losses to consumers based in part on extensive evidence that retail banking is the kind of intensely competitive market where almost complete pass-through tends to occur. In contrast, many of the merchant categories that would get the benefits of the interchange fee reductions are not intensely competitive. Most consumers, for example, have access to a small number of supermarkets and office superstores in their local areas. Using the geographic and product markets identified by the U.S. antitrust authorities, both of those categories are relatively concentrated compared to retail banking. Without detailed study it is hard to estimate what fraction of their cost savings firms in these industries would ultimately pass on to consumers. The handful of empirical studies conducted by economists point towards about 40-70 percent.
In the first 24 months after the Federal Reserve Board’s regulations come into effect, the large merchants would receive cost savings of $25.0 billion under the 12-cent cap proposal and $28.9 billion under the 7-cent safe harbor proposal. Based on the analysis above we believe that it is likely these large merchants would not pass on a significant portion of these cost savings to consumers in the form of lower prices in the first 12 months given that these cost savings are a very small percentage of sales and the evidence on price stickiness reported above. For the purposes of computing a rough estimate, suppose that they would pass on 10 percent of the cost saving in the form of lower prices in the first year. It is less certain how much overall the large merchants would pass on in the following 12 months. For the purposes of computing a rough estimate, suppose they would pass on 50 percent of the cost savings in the form of lower prices in the second 12 months (about the average pass-through rate in the studies cited above). Given these assumptions, large merchants would receive a windfall over the first 24 months of $17.2 billion in the case of the 12-cent price cap proposal and $19.9 billion in the case of the 7-cent safe harbor proposal.
To complete the merchant story we need to consider the merchants that have blended pricing contracts with their merchant processors. About 75 percent of merchants accounting for 25 percent of transaction volume have blended pricing contracts. The smaller merchants with these contracts typically have less bargaining power with their merchant processors than do large merchants. It is widely anticipated that merchant processors would not reduce their blended prices quickly in response to debit card interchange fee reductions. It is difficult to know how much they would reduce blended prices over time, but there is no presumption they would pass on 100 percent of their savings. As a result, the merchants on blended pricing may not see much cost savings to pass on to consumers, and they may not have much of a windfall.
The Impact of the Federal Reserve’s Proposal on Small Businesses
Proponents of the Durbin Amendment argued that it would help small businesses. We estimate that roughly 15.4 million small businesses have checking accounts. These likely include most active small businesses that are engaged in the sales of goods and services and therefore the preponderance of small businesses (those with fewer than 500 employees) based on the percentage of sales or employment. About one-eighth of the $15.7 billion ($1.96 billion) of debit-card interchange fee revenue that the Federal Reserve Board reported for 2009 came from purchases made with debit cards associated with small business accounts. The estimated debit card fee revenue per small business account for 2009 was roughly $109 ($1.96 billion in interchange fees divided by 18 million small business accounts where the 18 million exceeds 15.4 small businesses because some businesses have multiple accounts). The proposed reductions in debit card interchange fees would reduce that revenue by between $79 and $92 per account. Based on estimates of the fraction of debit card fee revenues due to small business accounts, we estimate that banks and credit unions would lose $4.2-$4.8 billion in revenues from small business accounts over the first 24 months after the proposed regulation went into effect.
Our analysis of how banks and credit unions would respond to the loss of the debit card interchange fee revenues indicates that they would promptly pass on much of the lost revenue to checking account holders in the form of higher fees or reduced services. As a result, the average small business account holder could expect to face higher fees or reductions in services that would account for a significant portion of the $79-$92 of debit card interchange fees that banks and credit unions would lose per account. In the aggregate then, small businesses would suffer a loss in the first 24 months of proposed rate caps approaching the $4.2-$4.8 billion of debit card interchange fee revenues that the regulation would remove from small business accounts.
Some small businesses also accept debit cards for payment and would obtain offsetting benefits to the extent that their merchant processors passed on reductions in debit card interchange fees in the form of lower blended payment card discounts. As we just discussed, however, it unlikely that merchant processors would lower blended prices quickly to smaller businesses or do so by anything approaching the full amount of the reduced debit card interchange fees.
The Durbin Amendment was presented as a boon to consumers and small businesses. Instead, the interchange fee regulations the Federal Reserve has proposed under that provision would impose billions of dollars of costs on these groups. The reason is simple. Competition will drive banks and credit unions to shift the loss of debit card interchange fee revenue to checking account holders in the form of higher fees and reduced services. Obviously, these banks and credit unions are not going to ignore a massive revenue loss. Consumers and small businesses with checking accounts necessarily lose when they react.
Consumers could get some of the money back if merchants lowered prices at the point of sale. But the economic evidence shows that merchants would not reduce prices much in the near term because the cost savings only amount to less than 2 cents on a $10 item. In the longer term, large merchants in many categories would pass on only a portion of their cost savings.
Small businesses could get some compensation for the losses imposed through predictable changes in the costs and services of their checking accounts and debit cards if they accept debit cards and if their merchant processors lower their fees. But most small businesses do not accept debit cards, and those that do are unlikely to see the debit card fee reductions quickly or fully. Thus small businesses will lose.
There is only one affected group that can be confident of doing well under the Federal Reserve’s proposal. The large merchants on interchange-plus pricing from their merchant processors could end up with windfalls of between $17 and $20 billion in the first 24 months after the proposed regulations go into effect, even after accounting for plausible amounts of reductions in prices to consumers.
 This paper is based on the Consumer Impact Study submitted to the Federal Reserve Board as a comment on Regulation II. We received financial support for large members of the Electronics Payment Coalition. For details including sources and calculations please see the Consumer Impact Study.
 The Washington Post, May 14, 2010. http://www.washingtonpost.com/wp-dyn/content/article/2010/05/13/AR2010051303571.html
 We’re focusing on 24 months because the Fed will collect more data after two years and possibly revise the regulations. Given all the changes that would likely take place in the debit card business following the rate reductions, it is hard to forecast out beyond two years.
 In all these calculations we are assuming that banks and credit unions with assets of less than $10 billion will end up facing the same reduction in interchange fees despite having an exemption from the interchange fee regulation. These institutions do not expect to get the benefit of the exemption because merchant and large issuer pressure would likely force interchange down to the same level as larger institutions and merchants would discriminate against high-priced cards from exempt banks and credit unions.
 Robin Prager, Antitrust in the U.S. Banking Industry (Presentation), Board of Governors of the Federal Reserve System November 30, 2007. Available at www.fdic.gov/bank/analytical/cfr/Prager.ppt.