Section 1075 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law on July 21, 2010, instructs the Federal Reserve Board to write specific rules governing debit card payments. On December 16, 2010, the Board issued its proposed interpretation of the legislative language of Section 1075-known in the payment industry as the Durbin Amendment, which includes two proposed alternative interchange fees standards. One of the alternatives contains an issuer-specific standard with a safe harbor (of 7 cents per transaction) and a cap (of 12 cents per transaction), and the other simply provides the 12 cent per transaction cap. At this time, the Board’s proposed Regulation II fails to allow for a fraud adjustment. While the Board is likely to allow an upward adjustment of interchange fees to account for fraud-prevention costs, this rule reportedly will not be finalized until after the interchange fee standards are set. The current proposal also includes two alternatives routing requirements, one that requires merchants be allowed no less than two unaffiliated networks overall and one that requires merchants be allowed no less than two unaffiliated networks per type of debit transaction (signature or PIN).
Proposed Regulation II has some obvious appeal, particularly to the Board, in its administrative simplicity. But this simplicity masks the main problem with the Proposal: it fails to account for the realities of debit card payments and seemingly ignores the interests of consumers.
The Proposal relies on the premise that debit cards and check are functionally similar. Given that checks clear at par, this premise should inevitably lead to interchange fees close to zero. In fact, the Proposal’s suggested interchange fee caps constitute an approximate 75% reduction in these fees. But the analogy to checks is far from perfect. Debit cards offer safety, convenience and payment guarantees that paper checks cannot. And these benefits, as the saying goes, don’t come for free. Both banks and payment networks incur potentially high fixed costs in providing debit card services–costs that the Board intentionally excluded when determining the proposed price caps.
That the Proposal sets prices at all is surprising. Neither the purpose nor the language of the Durbin Amendment seem to support such action. The Amendment instructs the Fed to “establish standards” for assessing when an interchange fee is “reasonable and proportional” to the transactional costs incurred by the issuer. Standard english and legal dictionaries alike define “standard” as “something established by authority, custom, or general consent as a model, example, or point of reference” or “something established by authority as a rule for the measure of quantity, weight, extent, value, or quality.” Setting an absolute and inflexible price cap is a very different thing.
But what is more worrisome is how the Board went about determining the price caps. The Board interpreted the Act to allow only the recoupment of costs associated with a specific transaction. The Proposal therefore only considers the costs associated with authorizing, processing and settling transactions. Fixed costs, including the costs associated with customer rewards programs or customer service, are explicitly excluded. But as the recent complaint for declaratory relief filed by TCF National Bank avers, the true expense of providing debit card services is reflected in the fixed costs.
With issuing bank facing a 75% reduction in interchange fees, the question that naturally arises is how will banks recoup the fixed costs associated with debit card services and who will bear this burden? The most likely answer is that the burden will be shifted to consumers through higher fees on deposits accounts and a reduction in the consumer incentives and rewards programs associated with debit cards. While there is the possibility that consumers will eventually gain an offsetting benefit from merchants who may lower prices to account for lower interchange fees, this possibility is far from assured. And one, based on comments and responses to questions to the staff during the Board’s December 16 meeting, that even the Board is not confident in. Also, given the amount that banks need to recoup (networks reported that 2009 interchange fees totaled $16.2 billion), even if only a portion of these fees are shifted to consumers (say 2/3 or approximately $10 billion), it is hard to imagine that lower merchant prices will wholly offset this burden.
While the Board says it understands and appreciates the importance of debit cards to consumers, it is disturbing how little the interests of consumers entered into its justification for the Proposal. The Board simply could not say whether consumers were likely to be better or worse off if the Proposal were to pass. And the stated justification for setting a price cap had nothing to do with the interests of consumers. Instead, the caps were justified by administrative convenience and a desire to avoid giving banks an economic incentive to continue inefficient practices.
But to ignore consumers is to ignore the other half of the equation. The debit card market is a two-sided one, with merchants who accept debit cards on one side and consumers who use them on the other. The Board justified the regulation of interchange fees on the grounds that competition in the debit card market actually drives prices up as payment networks raise interchange fees to attract issuing banks and their customers. The Board assumes this interplay indicates a market failure. But seeing this as a failure ignores that higher prices result from competition for users on one side of the market: debit card carrying customers. So while lower interchange fees may encourage more merchants to accept debit cards, at that point there may be fewer consumers who want to use them.
Katherine M. Robison is counsel in the San Francisco office of O’Melveny & Myers LLP and a member of the Antitrust & Competition practice group. The views expressed herein are the views of the author alone and are not the views or opinions of O’Melveny & Myers LLP or the publisher.
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