As the House and Senate conference commit- tee members negoti- ate differences in their versions of financial regulatory reform, one controversial provision is the late night amendment added by Democratic Sen. Richard Durbin of Illinois, which imposes price controls on debit card interchange fees. Under his amendment, the Federal Reserve would be required to set allowable charges of interchange at a rate “reasonable and proportional” to the incremental cost of processing the transaction.
Interchange fees on debit cards, a portion of the cost paid by the merchants when a consumer uses a payment card, currently average about 1.2 percent of the value of a transaction (credit card interchange fees are higher but are excluded from the price controls). The Durbin amendment would dramatically reduce this fee, most of all because it excludes the fixed costs of banks servicing consumers, a cost currently defrayed in large part by interchange fees. The result would be to shift those costs onto consumers, resulting in the end of free checking for many consumers, new fees or limits on debit card transactions and higher overdraft charges. In exchange, consumers are given a speculative promise that some undetermined part of this merchant cost reduction might get passed on to them in the form of lower retail prices. No guarantees, of course.
Mr. Durbin has defended this massive wealth redistribution from consumers to merchants on these pages as a response to Visa and MasterCard’s “absolute rule” over 80 percent of the payment card market, which supposedly allows them to stifle competition and to impose “unreasonable” interchange fees on merchants.
That’s good rhetoric but bad economics.
Mr. Durbin’s argument suffers from many flaws - least of all that it is squarely contradicted by developments in antitrust law and economics over the past three decades.
Consider the flawed economics that underlie the Durbin amendment:
Interchange fees are high because of the network duopoly:
First, of course, there is no duopoly in the payment card network once Discover and American Express are considered (not to mention Paypal and others). Second, serious economists long ago rejected the idea that market structure (the number of competitors in a market) determines whether a market will produce competitive outcomes. Markets with many competitors can nonetheless produce anticompetitive results and markets with few competitors often have vigorous competition (such as Coke and Pepsi). So instead of relying on crude indicators like market structure as a proxy for competition, antitrust economists and regulators require actual evidence of anticompetitive effect.
But mistaking market structure for competition is especially erroneous in the context of the payment card market. If insufficient competition among the networks mattered, then presumably the card networks would exploit consumers at least as much as they supposedly exploit merchants. But they don’t. In fact, those economists who believe that interchange fees might be too high - a view we do not share - argue that the problem, if there is one, arises from an excess of bank competition for customers, not a deficit of competition among networks. Under this theory, because consumers are the primary decisionmakers as to which cards to carry and use, issuers compete too aggressively for customers, producing excessively low prices for consumers. Higher merchant interchange fees are merely a byproduct of heated competition for consumers, not a scheme to exploit merchants. This is why higher merchant prices are mirrored by lower cardholder prices - and is precisely why if the Durbin amendment passes, cardholders will feel the bite.
If competition is driven primarily by consumer choice, then it doesn’t matter for merchants whether there are two, 10 or 20 payment networks. In theory, additional competition could exacerbate the problem and lead to higher interchange fees.
The current state of economic knowledge does not support the conclusion that low prices and spirited competition for consumers is a bad thing or that consumers and the economy will be improved by increasing bank fees for consumers. We do believe that a consensus of serious economic analysis holds that the presence of two major card networks in and of itself is largely irrelevant to the analysis.
Interchange fees are “too high,” which is evidence of market failure:
Mr. Durbin suggests that interchange fees are “too high” (others protest that debit fees have been rising, a debatable proposition for debit cards). But even if interchange fees seem high, focusing solely on the effect on merchants ignores the mirror effect of lower costs and improved quality for consumers, not to mention the social benefits of electronic payments, such as convenience, reduced risk of theft and loss and reduced tax evasion.
Merchant interchange fees reduce the consumer costs of owning and using debit cards. Such pricing interactions are common in what are known as two-sided markets. For example, newspaper readers pay much less than the actual cost of producing a newspaper because advertisers subsidize their purchases (some papers are even free). The newspaper exists to link up advertisers with readers, just as payment cards link merchants and shoppers. Moreover, the interaction between the price charged to consumers and advertisers is set to maximize the value of the newspaper, not by the cost of serving those two constituencies and certainly not to simply exploit one side for the benefit of the other. To observe in isolation that advertisers pay more than the cost of producing an ad without recognizing that readers pay less is blatantly misleading when offered as evidence of monopoly power.
Monopoly requires economic rents:
Economists dislike monopoly because it allows the monopolist to reduce output and increase price above competitive levels, thereby creating monopoly profits. Yet there is no evidence that credit card issuers or networks are earning monopoly profits from interchange fees (indeed, credit card issuers lost money last year) or that output is too low (critics claim that any market failure is because there are too many card transactions, not too few). The reason is simple - any profits generated by interchange fees are competed away in heated competition for customer loyalty through lower prices and improved card quality (including benefits). That card issuers cater to, rather than exploit, consumers belies the notion that a nefarious conspiracy to restrict competition is afoot.
To date, economists have not reached a consensus on the complicated question of whether the payment card market presents the rare situation in which consumers can actually be hurt by too much rather than too little competition or prices that are too low rather than too high. Empirical research is scarce. Instead of engaging in a serious economic analysis of interchange fees, however, the Durbin amendment is based on the simple-minded epithet of “duopoly” with no understanding of the past 30 years of antitrust economics. In the end, it will be consumers who will pay for this ignorance.
Todd Zywicki and Josh Wright are professors at George Mason University law school and fellows of the International Center for Law and Economics.