The Durbin Amendment has become a red flag to many in the payments world, evoking forecasts of doom, socialism, and, more concretely, pricing changes. Let’s put this topic in perspective.
First, look at the regulatory environment and history. Pretty much everyone in business today knows only the post-Reagan, post-Thatcher environment during which regulation was not only reconsidered but also frowned upon, to the extent that some regulators didn’t believe in regulation. American history from the late 19th century onward shows government involvement in business runs in cycles. This, plus a bit of common sense, should have suggested that the low-regulation environment was not permanent.
A very long and profitable business cycle ended in 2008, one characterized by easy credit and excessive leverage. Its end signaled an end to the low-scrutiny, low-regulation cycle we’d grown up with. More regulation was coming. Astute businesspeople noted and planned for it.
Second, consider the payment industry, particularly the Visa/MasterCard four-party model: cardholder, card-issuing bank, merchant-acquiring bank, and merchant, with networks connecting the two bank parties. This model has been tremendously successful in expanding electronic payment volume; with that increasing volume, and the increasing efficiency of payments processing, the pure cost of a transaction has dropped. At the same time, interchange rates have increased (see this 2009 paper from the Federal Reserve Board), and that increase transfers value from merchant to issuer. A large part of this increased interchange has been driven by rewards cards, which justify their higher interchange as needed to pay for cardholder benefits.
Visa and MasterCard — the networks — do not negotiate acceptance with merchants, yet they set interchange rates. As a result, merchants have little say in those rates. And interchange tables are complex; one network’s current table is 144 pages long. This makes it very difficult for merchants to know how much any given transaction costs. By contrast, American Express has just a few rates, so a merchant knows how much a transaction paid with an Amex card costs. And in many cases merchants negotiate acceptance directly with Amex, so it must convince them why the benefits of accepting Amex are worth the cost.
Why would a merchant want to pay extra for cardholder rewards, without any clear merchant benefit? Wouldn’t a better model be one in which merchants decide whether they want to pay for cardholder rewards, and could clearly track the benefit they receive? And if an issuer wanted to run its own rewards program, wouldn’t it be a better market if cardholders paid some portion of the cost, and could decide for themselves if the value was worth the price?
With the preceding in mind, the reactions we’ve seen from issuers and networks, while perhaps understandable, make little sense. The Durbin amendment, part of the sweeping Dodd-Frank legislation overhauling financial regulation, is not a particularly good piece of legislation. It simply transfers value from bank issuers back to merchants. But to hear it called socialism by an executive whose company is part of a duopoly is risible. The four-party model, coupled with increasing consumer appetite for borrowing, enabled a wonderfully profitable model for several decades. But times changed.
So how are bank issuers dealing with the changes? Thoughtful bankers have long known than profitability is best viewed at the customer level, by aggregating all the relationships a customer has with the bank. But not many banks have been able to do this, so when the profits and losses of the debit card unit suffer as regulation clips revenues, the banks increase fees, discouraging debit card usage. Any pretense to customer focus goes out the window.
Here’s where market forces may really come into play. We know customers like debit products. We know technology makes it possible to provide banking services without the overhead of legacy banks. We know several firms are trying to do this (e.g. Plastyc, Bank Simple, Mango Financial). We’ll see what happens.
Finally we have the networks, which just increased debit interchange to the maximum allowed for small transactions, costing merchants more (Durbin places a cap on debit interchange; networks previously had special low rates for small transactions, part of an effort to lure spending from cash to plastic). Think for a moment about the four-party model, and where it is weak. Whether through shortsightedness or petulance, the networks appear to be giving small and medium sized merchants another reason to seek alternatives to the four-party model. And many new firms are hoping to provide alternatives.
The four-party model will be with us for a long time; it offers something that works reliably and efficiently. But a lack of hindsight and foresight is leading issuers and networks to act in ways that will undermine their dominance and, ironically, could create a freer market in U.S. payments.
David True has worked in payments for 20 years and is an executive vice president at the consulting firm MCAWorks.