Twelve cents per transaction is the most banks will collect from merchants under the rules suggested by the Federal Reserve Board staff. Nothing is definite yet. The staff asked the Board to release proposed rules for purposes of getting comments. The Board of Governors agreed, and will decide the final rules later. At the meeting yesterday, none of the Governors pushed back much on the staff’s suggestions.
The Fed staff proposed two alternatives to debit interchange fee regulation. Both would set a maximum of 12 cents per transaction for debit cards with no distinction between signature and PIN. That’s about a fifth of what they are getting now for signature debit.
Under the first proposal proposal, there would be a safe harbor of 7 cents per transaction. If issuers collected less than that they would not be hassled by the Fed. What’s the magic of 7 cents? It is the median average variable cost of authorization, clearing and settlement costs of the issuers who gave the Fed data. Issuers could make a case for more—up to 12 cents based on their actual average variable cost of authorization, clearing and settlement. Under the second proposal, issuers would have a cap of 12 cents per transaction. The Fed staff said that 80 percent of the issuers had average variable costs below 12 cents per transaction.
The Fed staff has also presented two proposals for the number of networks that issuers have to offer on their debit cards. Under one proposal, issuers would be in compliance if the PIN and signature networks were provided by different entities. They are concerned that merchants that don’t have PIN pads would effectively have just one choice. Under the second proposal, issuers would have to provide choice of at least two independent signature networks and two independent PIN networks.
The issuers, networks, acquirers and merchants submitted a number of comments to the Federal Reserve Board staff with many of them arriving just before Thanksgiving. The Federal Reserve Board didn’t take the suggestions from merchants that the interchange fee be zero on the grounds that debit cards are functionally equivalent to checks, and that checks are cleared at par. The Fed staff largely ignored the comments from the issuers and networks. They declined to consider any costs other than straight authorization, clearing and settlement costs. They also seem to have taken a narrow short run view of the variables costs of these functions (it is hard to know without seeing their data analysis). They punted on the important question of whether banks are allowed to get a fair rate of return or just recover their incremental costs. The Fed staff reasoned that at 7 cents, 50 percent of the issuers (apparently by number, not volume) would be making something on top of the average variable costs of authorization, clearing and settlement while at 12 cents 80 percent would.
The Federal Reserve Board taking comments on the proposed rules through February 22, 2011.
The Governors asked the staff several questions. Here are a few I was hoping they would ask:
- The Federal Reserve Board is also a prudential regulator. What is the impact of the proposed rules on the safety and soundness of banks? Will there be a significant reduction in bank profits in the next few years while the banks re-equilibrate their prices and services? How will the proposed rules affect community banks and credit unions?
- Banks will lose a significant portion of the profits from the checking account services they provide customers as a result of the 80 percent plus reduction in debit card interchange fee revenues. They will probably have to increase fees or reduce services to customers. What are the implications of that for bank customers and, in particular, will there be a significant increase in the number of unbanked or underbanked consumers?
- There has been a great deal of innovation in payments in the last 50 years almost all of which has come from the private sector. The U.S. government has been very slow to move away from paper-based methods such as cash and checks. How will price regulation of debit cards affect the pace and direction of innovation?
I would also have liked to have heard more on the impact to consumers.
The staff was asked about this and candidly responded that they didn’t know—it was a complex topic with many countervailing forces in play they said. I think the answer is actually pretty clear as a matter of economics, and based on what happened in Australia, if the time frame is the next few years.
Consumers are going to end up paying more for checking-account and other services from banks. There seems to be a consensus on that one. The argument that consumers aren’t going to get the short end of the stick is therefore based on the claim that merchants are going to pass all of the cost savings on to consumers. So consumers pay higher bank fees but get the money back in lower retail prices.
This is fairy dust economics. Most merchants aren’t going to pass the reduction in debit-card interchange fees onto consumers in the near term. Cost reductions get passed on in part to consumers in the textbook model where prices can be easily and costlessly changed. In the real world, prices are sticky and they are particularly sticky downwards. Small changes in the cost of doing business are going to go right to the bottom line for most merchants. (The most you will hear from the merchants on this point is that the savings are too small to measure.)
Competition will result in some of those costs getting passed on to consumers eventually. But, if we’re looking at the next couple of years, I don’t think there is any doubt that the proposed rules will lead to more than a multi-billion dollar transfer of income annually from consumers to retailers.