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Both the Merchants and the Fed Misread Durbin

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A lawsuit brought by a group of retail associations and retailers against the Board of Governors of the Federal Reserve System asks the courts to find the board's rules to implement the debit card swipe fee requirements of the Durbin amendment to be "arbitrary, capricious and an abuse of discretion."

The suit would be interesting simply for being brought by the retailers that the amendment was intended to benefit. What is even more interesting is that, from my perspective, both the retailers and the board misread the Durbin amendment.

The Dodd-Frank Act provision referred to as the Durbin amendment established standards to limit the amount of fees, known as interchange fees, that debit card issuing banks collect each time a consumer swipes his card to make a retail purchase or to access. The interchange fees cover the cost of moving funds from the cardholder's bank account to the retailer's bank and related processing costs, as well as fraud prevention.

To implement the Durbin amendment, the Federal Reserve set a cap on interchange fees of 21 cents per transaction plus 5 basis points of the value of the transaction. The retailers allege that the board had it right in its initial proposal that set a 12 cent per transaction cap. In my view under a proper reading of the language of the statute, both the retailers and the Federal Reserve Board have it wrong.

The Durbin amendment is a last minute addition to the overhaul of the U.S. banking and financial system in response to the global financial crisis. No one, not even the provision's sponsor, Senator Richard Durbin, advocated that debit card swipe fees were somehow implicated as a cause of the financial crisis. The Durbin amendment nonetheless gained traction in what was seen as the need to protect retailers — and by extension consumers — from fees set by payment networks, such as Visa and MasterCard that process the debit transactions.

The networks arguably are more naturally aligned with issuers — as both derive their revenues from transaction volume. Given retailers' limited negotiating leverage, the legislation sought to limit the range of fees set by the payment networks by putting the onus on banks to charge a fee on each debit card swipe that is "reasonable and proportional to the cost incurred by the [bank] with respect to the transaction." If the Durbin Amendment was intended to deal with the payment networks' monopolistic-like control of the market, it resulted in the opposite. Any potential entrant would be hard put to recoup its start-up costs with the fee structure put in place by the board.

The statute left the Federal Reserve to "establish the standards for assessing whether any interchange fee . . . is reasonable and proportional" to an issuer's cost. The statute is clear and straightforward. The board is required to establish standards. Not fix a cap, whether at levels satisfactory to retailers or not.

If you don't believe this author, ask the statute's author. Senator Durbin made clear in his statement supporting inclusion of the provision in the financial reform legislation that the "Durbin amendment would not have the Federal Reserve set interchange prices."

So what do 21 cents and 5 basis points — or 12 cents — have to do with standards that are reasonable and proportional to an issuer’s transaction costs? Not much, based on what the Federal Reserve had to say in proposing the latter and implementing the former. It would appear that the 12 cents the board initially proposed is nothing more than the simple median per transaction processing cost for all kinds of debit card transactions — signature, PIN and prepaid — as reported by 89 debit card-issuing banks in response to a 2010 board survey. That 12 cent median cost corresponds to the median of the average costs for the three types of debit card transactions that range from 8 cents to almost 64 cents. The board's final rule revises the 12 cent cap to 21 cents, which the Federal Reserve says is the average per-transaction cost of the issuer at the 80th percentile in the survey based on a different universe of costs then those included in the original 12 cents proposed.

The board argues that Congress could not have intended to create a requirement that each fee received for each transaction be reasonable and proportional to cost as such a requirement would introduce tremendous complexity and administrative cost and would be "virtually impossible to implement." Difficulty in implementing a statute may give rise to a valid reason to ask Congress to reconsider and amend its terms. It does not confer on a government agency the authority to rewrite the statute to correct its faults. The board too is well aware that Congress knows how to require the board to establish pricing principles, which are akin to standards, and to implement a schedule of fees. That is what is done with Federal Reserve bank services. But it was not done with the Durbin amendment.

It may well be that a structure where each issuer would set its own swipe fee and that each issuer's federal banking supervisor would assess by applying standards set by the board to determine if each fee is "reasonable and proportional" is simply unworkable. With some 38 billion in annual transactions and growing, it is easy to see that this would be a formidable job for the federal banking supervisors. If it is ultimately determined that this is what the statute requires, it is Congress, not the Federal Reserve, which needs to remedy the situation. It may be said that the board did the best it could under the circumstances.

The board's implementation concerns, though undoubtedly with merit, do not justify ignoring the statute’s requirements. It may be as the retailers' allege that the cap chosen by the board is "arbitrary, capricious, an abuse of discretion." And it may be, too, that establishing a "reasonable and proportional" fee for each debit card transaction is "virtually impossible to implement" as the board says. Neither reason, however valid, justifies a cap. Period. A cap does not implement the statutory requirements of "reasonable and proportional to cost." The statute's framer made that clear. The Durbin amendment does not set swipe fees.

The plain language of the statute and the intent of its framers make clear that a cap does not meet the statute's requirement of "reasonable and proportional" fee standards. That should be the basis of a proper legal challenge. Perhaps a consumer group will find this a worthwhile undertaking as consumers come to realize that they have not enjoyed any pass-through benefit from lower swipe fees in the price of retailer goods and services, and face the prospects of increased bank fees to maintain their existing banking services. That too might be the impetus necessary to refocus Congress' attention on the shortcomings and untenable implementation requirements of their original legislation.

Ernest T. Patrikis, a partner in the New York office of White & Case LLP, is a former general counsel of the New York Federal Reserve.

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Comments (2)
There is less in accepting debit cards as the funds are secured. Credit cards are unsecured loans which the consumer can choose not to pay if s/he wants. Why then did debit cards process at a similar rate to the more risky financial product called a credit card? $0.21 is a more "reasonable and proportional" fee than 2.0%+ many processors were charging. Only downside are some merchants that process low dollar transaction ($10-$11 or less) that will pay a higher average processing rate. Those merchants always sign up with another processor if they want a better rate.

The other benefit is that because big banks felt they needed to charge a debit card usage fee (e.g. Bank of America $5/month), many depositors left for smaller bank with less than $10 billion in asset. This has created the net effect of redistributing money and power from several big banks to smaller banks. I see that as an encouraging part of an "overhaul of the U.S. banking and financial system".
Posted by sunk818 | Thursday, December 15 2011 at 5:08PM ET
"If the Durbin Amendment was intended to deal with the payment networks' monopolistic-like control of the market, it resulted in the opposite. Any potential entrant would be hard put to recoup its start-up costs with the fee structure put in place by the board."

The above quote from Mr. Patrikis' piece is true only if one presumes the interchange model is the only way to pay for a payments systems. It is not, and by decreasing the value transferred from merchant to issuer via interchange, other methods become possible. Since the issue has gets less revenue from interchange, consumers may we be compelled to more directly pay for what they get from a 4 party model payment. On the other hand, the merchants, paying less to accept payment, have more money for programs to drive consumer preference. And since Durbin allows merchants to favor one payment method over another, a whole new set of incentives become available. Say, for example, a Dwollo-like (ACH-based) method becomes available. Merchants can provide incentives to shift consumers payment method, and consumer not wedded to issuer rewards programs may shift.

Far from increasing 4-party model control, this may speed the lessening of that control.

David True
Posted by Herr Wahr | Friday, December 16 2011 at 10:20PM ET
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