October 1, 2011 marked a major watershed in commercial banking, for on that date, the Durbin Amendment, one of the most ill-conceived reforms of the Dodd-Frank Act, went into effect. Senator Dick Durbin (D – Illinois) added his amendment into the act at the last moment without any Senate or House hearing. The reform he implemented will revolutionize retail banking, and for the worse. Stripped to its core, this convoluted provision orders the Federal Reserve Board to institute a set of maximum fees that large banks—defined as those whose assets exceed $10 billion—can charge to their debit-card customers. Prior to the Dodd-Frank Act, these fees averaged about $0.47 on the typical $35 purchase. Small banks can do business as they did before.
Illustration by Barbara Kelley
After much preliminary skirmishing, the Fed capped the permissible rate to about $0.24 for the typical transaction, thereby digging a $6.6 billion balance sheet hole for the large banks. Those banks now have to look elsewhere for their lost revenues. Bank of America has, according to New York Times reporters Ron Lieber and Ann Carrns, the "nerve" to impose a $5 monthly debit-card fee on most of its customers—except for those who maintain high bank balances. Other banks have imposed smaller fees between $3 and $4. Still others have stood pat for now.
Those fees turn out to be a big deal. Though Lieber and Carrns denounced the fees as a "tax on pretty much every customer without a healthy salary," they did not bother to point the finger at Senator Durbin for the tax. Lieber and Carrns urged customers to bank elsewhere. Given that threat, they may have to. As George Mason Law’s Todd Zywicki reports in the Wall Street Journal, small branches are closing, free checking accounts are evaporating, and marginal customers are being driven from the banking system to cash exchanges, pawn shops, and high-priced prepaid cards. There is no magic with price controls. They do for banking what they do everywhere else: create product shortages and spawn regulatory intrigue.
The Durbin Amendment will revolutionize retail banking.
It wasn’t supposed to work out that way, of course. At the height of battle, Senator Durbin took to the Senate floor in fine populist rhetoric to denounce Visa and MasterCard for their evil cartel with the issuing banks. Every step of the way, he was backed by the National Retail Federation and its general counsel, Mallory Duncan, who stressed time and again that the actual costs of running a debit interchange system were only a tiny fraction of the bloated fees. So the Durbin Amendment asks the Federal Reserve to implement this policy in setting rates, by differentiating between:
(i) the incremental cost incurred by an issuer for the role of the issuer in the authorization, clearance, or settlement of a particular electronic debit transaction . . .; and (ii) other costs incurred by an issuer which are not specific to a particular electronic debit transaction. . . .
For the Fed to allow $0.24 cents in the teeth of this language was an act of calculated mercy. But the damage of the bill is large enough to ask two post-mortem questions: how did the Durbin Amendment go off the tracks? What should the courts have done about it?
Let’s start with how debit interchange works. The central challenge organizing this market is to figure out how to integrate tens of millions of debit-card customers with millions of retailers. It takes only a split second to realize that direct contacts between each individual cardholder and each individual retailer can’t work given the high transaction costs needed to knit this system together. Without the kind of government subsidies that go into cash and checks, Visa and MasterCard set up separate network platforms that knocked out most of those transaction costs. But these companies could not do the job alone. An issuing bank is needed to line up customers. A merchant bank is usually needed to line up merchants. Neither side will come to the party, moreover, unless it knows that the other side will also come.
The debit-card system not only linked people together; it also allowed for the intelligent use of data by merchants and spared them and their customers the real costs of using checks and cash. Most critically, the debit-card system exploited some underappreciated efficiencies of a "two-sided market." To most people, this term sounds like a redundancy, because any market with buyers and sellers, landlords and tenants, lender and borrowers, must have two sides. So what makes payment cards, both credit and debit, special?
The answer is that in these networks a payment across the platform from one side of the typical transaction will improve the overall operation of the network by keeping the more reluctant party in the system. That is why restaurants and clubs often levy different cover charges on men and women, using the extra revenue from men to erase what would otherwise be a shortage of women, which would in turn doom the whole enterprise.
Banks now have to look elsewhere for their lost revenues.
Debit-card (and credit-card) networks work the same way. In an open market, merchants pay subsidies to have issuing banks lure new cardholders into the system. Where that is not done, as in Canada, the system is less innovative, with higher customer usage fees and slower introduction of new services like debit-card use for online and foreign purchases.
Someone has to pay for this interchange infrastructure now that the fees are excluded under the Durbin Amendment’s absurdly narrow view of cost. Now that the wreckage has hit the beach, it is not surprising that Senator Durbin no longer bellows from center stage about abusive practices and excessive costs. The current reality is this: no one can document how merchants have passed on their cost savings from the Durbin Amendment. But the inconveniences in the debit card market are everywhere to be seen. Senator Durbin used to crow that banks should charge their own customers in order to help retail consumers. He forgot to note how these two populations overlap.
The legal side of this unfortunate legislation is every bit as troublesome as the economic side. If previous debit interchange practices were cartel-like, why haven’t the merchants or the government sued under the existing antitrust laws? Because their case is a dead loser so long as the separate platform operators don’t collude. So instead Senator Durbin and his retail allies waved the false banner of debit-card collusion to slap sharp restrictions on costs, which in turn set up a legal challenge to Durbin’s amendment, which went down in flames in the Eighth Circuit this past June, in TCF National Bank v. Bernanke (on which I consulted with TCF through the trial stage).
Any constitutional challenge to economic regulation today faces an uphill battle given the near canonical status of the highly deferential "rational basis" test, which lets the government get its way so long as it can provide some reason for its action. Thus the Eighth Circuit let the Durbin Amendment pass because "it does not restrict how much those institutions may charge their customers for the privilege of using their debit-card services." Yet since the Eighth Circuit did not explore the behavior of two-sided markets, it did not see that by cutting out the debit interchange, the substitute dollars extracted from the bank’s own customers would necessarily come up short. That conclusion holds even if the regulated banks did not lose a single customer to their unregulated competitors. This is doubly true now that we know that even a $5 per month charge can lead to a major customer exodus.
Competition from small banks will increase the revenue losses of bigger banks.
The Eighth Circuit decision, moreover, muffed the central constitutional issue by using the low rational basis test, which under current law is inapplicable to businesses that have committed their capital to the venture prior to regulation. With natural monopolies like electricity, power, and (at one time) telecommunications, current law requires the government regulator to avoid the risk of confiscatory rates as it seeks to control monopoly profits. Hence these regulated utilities are entitled to receive an economic return that allows them to attract and retain capital.
So here is the rub. The risk of confiscation remains for banks in competitive industry. But now there are no monopoly profits to constrain. The banks that have invested billions in their debit-card systems are squeezed by Durbin’s slash in the rates. Surely they are at risk of confiscation. The District Court responded to this challenge by saying "there is no monopoly power assumed to be associated with issuing debit cards. Plaintiff is not a public utility under rate case jurisprudence."
This short passage gets it all backwards. The assets of issuing banks are trapped in the ground just like those of the public utilities. But why run the risk of rate regulation when there are no monopoly profits to restrain what was recognized to be the highly competitive debit-card market? Once we are certain that customer charges can’t make up the difference, the law should have been struck down unless the government was willing to pony up the difference.
Those differences were large, given that there are three strikes against the Durbin Amendment. Strike one: owing to the efficiency of two-sided markets, replacement revenues can never equal lost revenues. Strike two: competition from small exempt banks will increase revenue losses. Strike three: administrative costs further eat into profits. If either the Eighth Circuit or the District Court had understood the economics of regulation, this case would have come out the other way.
The greater tragedy, however, lies in the overheated political scene that allows demagogues like Senator Durbin to get his way. The current economy has enough trouble without the Durbin Amendment. One of the economy’s bright spots was the debit card, which in hard times became the life-line of millions of people. Its use, measured both by card swipes and dollar levels, far exceeded that of the credit-card. What possible reason is there for Congress and the president to meddle in one of the few systems that work, even if the courts will roll over to whatever they do? There is no one thing that can fix the American economic system or its horrific political climate. But the prompt repeal of the odious Durbin Amendment would be a fine place to start making amends.