David Evans, Robert Litan, Richard Schmalensee, Mar 30, 2011
The Board of Governors of the Federal Reserve System (“Board”) is the latest of a series of central banks and antitrust authorities to tackle the thorny issues of interchange fees. It did not ask for the job. During the process of drafting financial reform legislation the U.S. Senate passed the “Durbin Amendment,” which required the Board to regulate the amount of interchange fees that banks that issue debit cards could receive. That amendment became part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act was passed by Congress and became law on July 21, 2010.
The Durbin Amendment instructed the Board to adopt rules that would ensure the interchange fees banks received were “reasonable and proportional” to cost. The amendment said the Board should consider “the incremental cost incurred by an issuer for the role of the issuer in the authorization, clearance, or settlement of a particular electronic debit transaction” but should not consider “other costs incurred by an issuer which are not specific to a particular electronic debit transaction.” It did not elaborate on what was reasonable. The Board was given until April 21, 2011 to adopt the rules, and the rules are supposed to go into effect on July 21, 2011.
The Board staff started its work shortly after the legislation was signed into law. It appears that the staff focused much of its effort on collecting data and information from the issuers, acquirers, networks, and other industry participants. A key part of the data collection focused on the costs incurred by banks for providing debit cards to their customers. The staff found that the volume-weighted average variable cost of authorization, clearing, and settlement was 4 cents, the median was about 7 cents, and that 80 percent of the surveyed banks had average variable costs less than 12 cents.
The staff devised two alternative proposals that were presented formally to the Board at an open hearing on December 16, 2010. Under the “12-cent cap” proposal a bank would be in compliance so long as it did not receive debit card interchange fees of more than 12 cents per transaction. Under the “7-cent safe harbor” proposal the bank would be in compliance so long as it did not receive debit card interchange fees of more than 7 cents per transaction or its actual average variable costs up to a maximum of 12 cents (the “7-cent safe harbor”). The average debit interchange fee was 44 cents per transaction in 2009 according to the Board. The 7-cent safe harbor proposal would therefore decrease debit card interchange fee revenue by 84 percent, while the 12-cent cap would reduce fee revenue by about 73 percent. After a series of questions to and responses from the staff, the Board agreed to issue the proposals for public comment.
In considering the Board’s proposals, this article focuses on the principles for regulating debit card interchange fees and, in particular, examines what the source of the problem is and what the best solution to that problem is from the standpoint of the public. In the language of regulatory economics we address: What is the market failure that is the source of the problem and what is the best remedy for that problem? Our analysis therefore has implications for interchange fee regulations by central banks and competition authorities worldwide.
