Politicians always feel the need to respond to any crisis with legislation. The Dodd-Frank Wall Street Reform Act was a predictable response by Congress. One of its many provisions is the Durbin amendment, which directs the Federal Reserve to establish limits on the amount of interchange fees that can be charged in debit card transactions. The amendment was a major victory for merchants who have long objected to the fact that they have to pay interchange fees on debit card transactions, while there is no direct cost in accepting checks.

Interchange fees for debit cards average 1.6% of the transaction amount, while fees for credit cards average 2%.

The participants in the debit card payment system are the issuing bank, the network provider who processes the transactions, the consumer who uses the card to make purchases and the merchant who receives payment.

The consumer wants to make a purchase simply, efficiently and without added cost. The issuing bank prefers the debit card to traditional checks because the cost to process electronic debit card transactions is much lower and the bank earns income on the interchange fees to help offset the increased risk it accepts in the transaction. Network providers derive income from the volume of transactions they process and anything that causes a decrease in transactions will cause a decrease in revenues.

With debit card payments, merchants eliminate the risk of insufficient funds as well as other causes for nonpayment posed by paper checks, get quicker access to the funds than by any payment means other than cash and receive payment more efficiently with less handling by employees. By accepting debit cards as payment, the merchant transfers to the financial institution issuing the card the majority of risk the merchant faces in the transaction.

The merchants found the perfect vehicle to attack interchange fees. The Durbin amendment requires that all interchange fees charged "with respect to an electronic debit transaction shall be reasonable and proportional to the cost incurred by the issuer with respect to the transaction." The Fed is directed to prescribe regulations by April 2011 with an effective date for the law of July 2011.

In determining what is "reasonable and proportional," the Fed is to "consider the functional similarity between electronic debit transactions and checking transactions that are required … to clear at par." Further, any costs not specifically related to a particular debit card transaction, such as equipment and software costs and general overhead required to support the payment function, are to be disregarded. Other than directly related costs, the only cost that may be considered by the Fed in setting the maximum fee allowed is costs "reasonably necessary to make allowance for costs incurred by the issuer in preventing fraud." Under this definition, a bank is not allowed to recover its fixed costs in building its electronic payments system or its general overhead in maintaining the system, is not allowed to earn a reasonable profit on its investment and is allowed nothing for incurring most of the risk in the transaction.

Proponents of the Durbin amendment argue that most issuers will not be affected because of the "small issuer" exemption. This exemption provides that the Durbin amendment's limitations will not apply to any issuer with assets of less than $10 billion. The American Bankers Association, however, disagrees. It contends that the exemption will not protect smaller banks because they will have to lower their fees to remain competitive or risk losing market share. This shift in market share may be accelerated by large merchants offering additional discounts or other rewards to customers that use large bank cards.

Merchants contend the Durbin amendment will help lower prices for customers. Others are skeptical that merchants will ever pass any savings on to consumers. Analysts predict network providers will lose revenues. The biggest losers, however, appear to be issuing banks and their customers. The ABA predicts the provision will cause bank account fees to rise to offset the loss of income, will make it very difficult for banks to offer low- and no-cost checking and may cause up to a $74 billion decrease in lending if interchange income drops by 50%.

Systemwide impacts may be even more fundamental. Most smaller banks will not continue to offer debit cards if the risk of loss and associated cost outweighs the income and benefit derived from offering the cards. It is conceivable that many banks will drop their debit cards and only offer ATM cards. Customers will then have to rely more on credit, checks and cash for their transactions. Each of these payment options introduces less efficiency into the payment system. The end result will likely be less convenience for customers, more cost and a less efficient payment system as a whole.

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