In the evening of May 13, 2010, a shock wave went through the payments industry. The Senate overwhelmingly passed a bill that, at first blush, enables regulation of Debit Card fees – both Interchange and Network fees. Obviously, it still needs to get through Congress, but it has made it a lot further than most industry experts thought.

Personally, I take a slightly different ownership when anything gets amended to the Electronic Funds Transfer Act. Sometimes, people say that I have payments in my blood. It is almost true. Back in 1976, my father, Jack Benton, became the Executive Director of the National Commission on Electronic Funds Transfer (appointed by President Gerald R. Ford). His work leading that Commission became the substantive work for the Electronic Funds Transfer Act – the exact law that Senator Durbin is trying to amend.

But this is not about me feeling like my father’s work should not be questioned. This is about the state of the industry today coupled with the reasoning behind how we got here.

Reasonable Fees

Let’s look at a few excerpts from the amendment to make sure we can really answer whether or not this is smart legislation.

‘‘(2) REASONABLE FEES.—The amount of any interchange transaction fee that an issuer or payment card network may charge with respect to an electronic debit transaction shall be reasonable and proportional to the actual cost incurred by the issuer or payment card network with respect to the transaction.”

Sure – this sounds great. Interchange should reasonable. But here is where it is wrong. Interchange is not just about the payment for cost incurred by the Issuer. It is a transfer of value for the right to access the DDA account. If I were writing such an amendment, I would change it to read:

‘‘(2) REASONABLE FEES.—The amount of any interchange transaction fee that an issuer or payment card network may charge with respect to an electronic debit transaction shall be reasonable and proportional to:

a) the actual cost incurred by the issuer or payment card network with respect to the transaction
b) the value of the transaction to the acquirer (merchant)
c) the burdened cost of competing transactions for the acquirer (merchant)”

We need to look back in history to realize that Interchange was never just about cost recovery. There needed to be a reason to issue the cards. The retailers wanted a more comprehensive electronic payment, and it cost big money (especially then) to issue cards and manage a program. The Issuers had to believe in a business case for the investment. Granted, I don’t think many thought it would be such a significant revenue stream, but that was the gamble.

Also, let’s look at the acquiring side. Checks are cheap to process for the Issuer, but merchants are loathe to take them because of the fraud, back-office processing for them, and the increased line time. Almost every merchant would rather take a debit transaction. So why would the price need to come down when compared to its analog?
Oddly, the amendment specifically addresses checks, but only as to the cost for the Issuer to process, not the burden cost of acceptance by the Retailer:

‘‘(4) CONSIDERATIONS.—In issuing rules required by this section, the Board shall—

‘‘(A) consider the functional similarity between—

‘‘(i) electronic debit transactions; and

‘‘(ii) checking transactions that are required within the Federal Reserve bank system to clear at par;

‘‘(B) distinguish between—

‘‘(i) the actual incremental cost incurred by an issuer or payment card network for the role of the issuer or the payment card network in the authorization, clearance, or settlement of a particular electronic debit transaction, which cost shall be considered under paragraph (2); and

‘‘(ii) other costs incurred by an issuer or payment card network which are not specific to a particular electronic debit transaction, which costs shall not be considered under paragraph (2);…”

Exemption for Small Issuers

Let’s look at another aspect of the amendment:

‘‘(5) EXEMPTION FOR SMALL ISSUERS.—This subsection shall not apply to issuers that, together with affiliates, have assets of less than $10,000,000,000, and the Board shall exempt such issuers from rules issued under paragraph (3).”

As Senator Durbin discusses openly, 99% of the Issuers will not be subject to this amendment. However, over 65% of debit transactions come from the 1% that are not “small issuers.”
This could create a significant shift in the marketplace.

Currently, most Debit Network interchange models vary based on the size (assets or transactions) of the Retailer: the bigger the retailer, the smaller the Interchange amount. However, this could now shift. The Issuers that are small, as defined by the amendment, may be compensated significantly more for the debit transaction (Interchange) than a large bank. That means that they could offer greater customer incentives, such as reward points. Is this enough of an incentive to lure customers? Obviously that depends, but it might even the playing field a bit.

But it also could create a bigger divide between the large retailers and small issuers. Currently, the small issuers, which have far less value to a retailer than the large issuers, are supported by Network grouping everyone together. This almost acts like a labor union. Segmenting Interchange based on Issuer asset size may make small issuers obsolete.

Read the full Amendment here:

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  • John MacAllister

    Then there’s the problem of smaller issuers (who cannot be discriminated against by retailers under Durbin’s amendment) versus the networks they belong to (which can be). For instance, CU24 and AFFN include thousands of credit unions (smaller issuers by definition) and a handful of community banks (ditto). While Durbin excludes predatory retailer behavior at the FI level, there’s no similar prohibition against merchants priority routing these two FI-owned institutions and others like them into non-existence.

  • Christie Christelis

    Two comments to add to the discussion:

    (1) I think that this type of legistlation is not atypical for network industries. The fear of the legislature is that networks will abuse their dominant positions in some way (this has been known to happen and is rife for interconnection in the telecommunications environment, for example)
    (2) Given (1) above, regulators try to force a pricing system that is related to cost (but not equal to cost) and there is a mechanism to get a return, usually equal to WACC, to absorb common or joint costs, and so on. This is often based on LRIC models. There is also a desire to promote investment into the network, or at the very least, not inhibit investment into the network.

    So there is no question of the regulated price equalling the cost price. The goal is to try to prevent anticompetitive behaviour in pricing (and access). Regulators are also often mandated to prevent cross-subsisdization of the one business area to another in cases where downstream activities are competitive of those with their clients and cost-basedc pricing forces balanced rates.

    While the goals are laudable, this makes the regulation very complex and requires the regulator to build capacity and expertise to deal with these issues. This can be a significant cost to the state and to businesses that have to comply. But in situations where there is some element of market failure, there is often very little option but to go down that route. And expecting a regulator to pass judgement on the value of a transaction to an acquirer will be even more problematic than mandating a cost-based approach.

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