When regulators slash interchange fees—as they’ve done in Australia, Spain, and of course the United States—do consumers win or lose? One camp says they win since, of course, merchants are going to pass those savings on to consumers in the form of lower prices. What’s not to love about that? Another camp says, naturally, consumers lose because their banks are forced to charge them higher fees to make up the lost revenues. Anyone who thinks merchants are going to cut prices because of the savings they received as a result of Durbin probably believes in the tooth fairy, too.
Both camps express these views with great vigor. That’s so despite the fact that the changes in interchange fees are so small so that it would be hard to separate a price change from everything else going on in retail even if merchants gave all of their savings back to consumers.
The first camp claims that basic economics shows that retailers will give 100 percent back—after all, that’s what firms in perfectly competitive industries do, which you would know if you hadn’t been dozing through Micro 101. The other camp says, well—show us the money!
A study I’ve just completed with two colleagues at Global Economics Group, Howard Chang and Steve Joyce, shows that both camps are wrong. Merchants did, in fact, give some of the savings back to consumers, but not enough to offset the amount that banks passed on to consumers as a result of their loss of revenues. As far as I know, this is the first study to estimate how much money consumers saved at retailers—putting aside from the vigorous handing waving from the two camps above.
All in all, consumers took it on the chin for $22 billion and possibly more. That $22 billion is the present discounted value of the losses to consumers, starting in October 2011 when the caps went into effect, and off into the future.
To explain how we came up with these figures, we need to take a quick detour into the financial markets. The market capitalization of publicly traded firms reflects investor beliefs about the present discounted value of the profits of those firms. Market capitalization is calculated by multiplying the share price and the number of shares outstanding. When there is good news about a company’s prospects, the stock price typically rises along with its market capitalization. The reverse is true for bad news.
Financial economists have developed an econometric methodology known as an “event study” that relies on the relationship between news, stock prices and market capitalization. It calculates the impact of the “event” by examining how the event affected the returns of publicly traded firms that were impacted by that event.
Economists believe that event studies provide reliable estimates of the impact of an event and have conducted hundreds of these studies over the years. The courts have come to rely on event studies to assess a variety of issues in securities litigation. A longstanding decision by the Supreme Court supports their use and a number of Circuit Courts have upheld the use of event studies as well.
A few years ago, James Surowiecki’s book, The Wisdom of the Crowds, explained why the average of estimates by a very large number of people is often highly accurate. Financial markets are based on a very similar concept. Any one investor may make a bad prediction. But when these predictions are averaged together—as they are effectively in the price at which a stock is traded—errors on one side balance off errors on the other side. Event studies, in effect, just calculate the average estimate, by the very large crowd of investors, of the impact of an event. Of course, these experts are highly motivated to come up with accurate estimates. They lose money otherwise.
When retailers got good news about debit interchange fee reductions, the stock prices of many of them went up after controlling for other factors in the market. The bank stock prices went down. Those market movements reflected the market’s view that the retailers would earn more profits over time as a result of the interchange fee reduction, but that the banks would earn less. We did a statistical study that isolated the impact of the good news/bad news for retailers and banks in two events. First, when the Federal Reserve Board proposed slashing interchange fees by about 80 percent on December 16, 2010. This event was relatively good news for merchants and relatively bad news for banks. Second, when the Federal Reserve Board, on June 29, 2011, announced a less draconian reduction of interchange fees merchants pay of about 45 percent. This event was relatively bad news for merchants and relatively good news for banks.
Using these estimates, we calculated the profit changes for retailers and banks. We did this for publicly traded organizations and then projected the estimates to the full population of merchants and banks. After projecting our results for publicly traded firms to all firms we found that the market capitalization of merchants increased by $38 billion and the market capitalization of banks decreased by $16 billion. Our estimates were statistically significant at more than the 99 percent level of confidence and our econometric models passed a battery of tests for their reliability and robustness.
It turns out that, with a little bit of math, we can show that the cost to consumers is the difference between the loss of profits by the banks and the gain in profits by the merchants. If, for example, merchants saved $1000 in interchange fee reductions and used those savings to increase their own profits by $400 there would be $600 left over for consumers. What banks don’t absorb through lower profits they recover from consumers in the form of higher fees or reduced services. In other words, for example, if banks lose $1000 of interchange fee revenue but only lose $300 in profit they must have made up the difference by raising fees to consumers in the amount of $700.
Using estimates of bank and merchant profits changes from the Federal Reserve’s regulation into this formula, the net effect to consumers is $22 billion ($38 billion-$16 billion). That figure reflects the present discounted value of the losses faced by consumers.
For consumers, there is tangible evidence of the impact on them. Facing a loss of more than $7 billion in revenues in 2012, banks raised many rates and reduced services in anticipation of the interchange regulation and after the announcement and implementation of these price caps. In its 2012 Checking Survey, Bankrate.com found that almost every category of checking account fee had increased over 2011 levels. The percentage of free checking accounts declined from 45 percent to 39 percent. The average monthly maintenance fee for non-interest checking accounts rose 25 percent. The average minimum balance required to avoid fees rose 23 percent. The average fee charged by banks to their customers for using an out-of-network ATM rose 11 percent, in addition to a 4 percent increase in the fee charged by ATM owners.
The fact that the Durbin Amendment resulted in a wealth transfer to retailers from consumers and banks is not surprising. The regulations shifted more than $7 billion of money from the annual income of banks to the annual income of merchants. There is no reason to believe that merchants would give this windfall back to consumers or that the banks could absorb the full loss in their profits. A wealth of economic studies shows that does not happen in the real world. But, the bill to consumers over time will add up to at least $22 billion, and potentially more.
David S. Evans
David S. Evans, is the Chairman of the Global Economics Group in the firm’s Boston office, and has broad experience in the economics of antitrust, intellectual property, and financial regulation. Dr. Evans has an international practice and has worked on matters in the United States, the European Union, China, Brazil, Australia, and other jurisdictions. He has provided economic advice on a wide range of industries but has special expertise in financial services, internet-based, media, and information-technology based businesses. He is one of the world’s leading authorities on platform-based (“two-sided market”) businesses.
Dr. Evans currently teaches economics and antitrust at the University of Chicago Law School where he is a Lecturer and at the University College London where he is a Visiting Professor. He is the Founder and Publisher of Competition Policy International and is on the editorial boards of Concurrences and The Review of Network Economics. He has authored or edited 8 books and more than 100 articles and book chapters.
Dr. Evans was a Managing Director of LECG (2004-2011) where he was the head of its global antitrust practice and Vice Chairman of LECG Europe. Previously he was Senior Vice President at NERA (1989-2004) where he was also a member of the management committee and board of directors. He received his Ph.D. in Economics from the University of Chicago in 1983 and subsequently taught at the Department of Economics and the Law School at Fordham University in New York.