Last week, the Federal Reserve Board delivered a hammer blow to the entire debit card industry. Pursuant to its congressional marching orders under the so-called Durbin Amendment to the Dodd-Frank Act, the Fed was charged with setting the interchange fees that Visa and MasterCard charge merchants to cover their own expenses and those of the banks that issue debit cards to consumers. The Fed then exercised its new-found administrative mandate by slashing those fees by perhaps 90 percent, producing an immediate sell-off in the stocks of the two payment networks, Visa and MasterCard.
Price controls in dynamic competitive markets are rightly regarded as an anathema. Predictably, therefore, the Fed’s new measure threatens to derail the most recent dramatic innovation in consumer payments. By 2009, debit cards displaced credit cards as the main form of payment. Debit accounted for 38 billion transactions with a cash value of $1.45 trillion. For signature debit, the average interchange fee is about 56 cents, or just over 1.50 percent on an average $30 transaction. The numbers for PIN debit were lower, at 23 cents and 0.56 percent, respectively.
Checks clear at par because of extensive government subsidies. In contrast, debit cards are financed solely out of fees from system users. Pricing debit cards services is complex because the card networks operate as the fulcrum in a so-called two-sided market that emerges to solve a mutual assurance problem for both customers and merchants. Each side needs to know that the other will join the network before it commits. The cost-minimizing strategy places the cost of running the network on merchants, who are less sensitive to price shifts. Through the interchange, they pay the issuing banks, who then invest heavily in creating the network and recruiting customers to it. The lure of free checking attracts consumers in droves and drives down systemwide costs.
This infrastructure and these services don’t come cheap. Yet there is zero evidence that the issuing banks earn in excess of a competitive rate of return. Instead, the speed, reliability, record keeping and safety of debit cards have generated gains for all - at least until Sen. Richard J. Durbin, Illinois Democrat, upset the apple cart. Unfortunately, his amendment is a classic bait-and-switch operation. First, it says modestly that debit fees shall be “reasonable and proportional” to an issuer’s cost. But it then mandates that the Fed may “consider” only “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,” or “acs” fees.
Apart from these acs fees, recovery of any other cost is statutorily forbidden, period. Excluded are all the fixed costs of investment, maintenance and upgrade, along with all the variable costs of customer service. These costs, the Fed suggests, issuing banks may recover from cardholders. That task, however, is made infinitely more difficult because Mr. Durbin’s amendment survived the political thicket only by exempting banks with assets under $10 billion from its rate controls. Alas, the right of “big” banks to raise customer fees rings hollow if those customers can migrate to smaller banks not burdened by the Durbin Amendment, which can still offer free debit card accounts.
The Fed’s regulation ignores this larger landscape. Unfortunately, its narrow focus ignores the elephant sitting on the front lawn - the serious constitutional challenge that TCF Bank of Minnesota has lodged against rates that are “confiscatory” under applicable Supreme Court law. The Fed acknowledges that current law protects public utilities against unduly low government rates. More precisely, to guard against state confiscation, the Constitution guarantees public utilities and other firms a reasonable rate of return on their investment, equal to the risk-adjusted return that ordinary firms obtain in a competitive market.
The Fed should have examined the constitutional issue much more closely. Missing from its account is the reason rate regulation makes sense for public utilities. Utilitiesare “natural monopolies” that, if left regulated, could earn unduly high rates of return because of the total absence of any competitors in their geographical territory. Rate regulation is the law’s antidote to their monopoly power. The regulator has to require public utilities to serve all customers so that no one is literally left out in the cold.
At the same time, rate regulators cannot lower rates to starve the utility of the capital needed to run its business. Debit card customers have a choice in banks, so there is no need to mandate any bank serve any particular customer. Yet banks also have capital needs, which is why, if anything, they need greater protection against government confiscation by arbitrarily low rates.
Nor can these banks recover their lost revenues by adding customer fees as the Fed claims. Those fees will not begin to recoup the losses that the Fed’s restrictions on interchange fees will cause next year. Right now, customers get debit cards for free. Big banks that impose fees will collect virtually no revenue if small banks remain exempt from the Durbin Amendment. If, in the future, the small banks are somehow forced by Visa and MasterCard to accept the same confiscatory rates as the large ones, both set of banks will lose. The bottom line is that under no conceivable scenario does the Durbin Amendment allow the regulated banks to earn the constitutionally guaranteed rate of return.
The silver lining is this: The Fed’s proposed rate schedule has alerted the major players in Congress that the Durbin Amendment threatens banking disaster. For example, Rep. Barney Frank, Massachusetts Democrat, is already on record that he voted for the Durbin Amendment only to get the rest of Dodd-Frank passed. He rightly believes that the free market should set exchange rates. Repealing the Durbin Amendment does that, and spares the nation a major legal donnybrook over its constitutionality.
Richard A. Epstein is a professor of law at NYU and a fellow at Stanford’s Hoover Institution. He represents TCF bank in its litigation on the Durbin Amendment.