One of the great financial innovations of the 1990s was the now ubiquitous debit card. But its salad days may well be coming to an end. Why? Because of two events. First, the Federal Reserve in 2011 set rates for debit card transactions at $0.21 per transaction. Second, Judge Richard Leon of the Southern District of New York set recently aside two of the Fed’s regulations in NACS v. Federal Reserve.
In the case, the Fed was sued by a group of retailers who claimed that its rates were too high. Judge Leon ordered the Fed to order new rates, which will approach $0.03-0.06 per transaction. Many observers fear that Judge Leon’s decision will create “turmoil” in the debit card industry. The full story bears some telling.
Back in 2011, the Fed adopted its regulation pursuant to the authority conferred on it by the so-called 2010 Durbin Amendment (which I have written about here and here). The amendment was a last minute add-on to the comprehensive Dodd-Frank legislation. Before its passage, debit card fees were determined by prices set by the voluntary market that had five key players. Sitting in the middle were the network platforms, chiefly Visa and MasterCard. On the one side of that platform were the retailers who operate through merchant banks. On the other side were the issuing banks whose customers use debit cards.
The standard business practice required the retailers to pay a debit interchange fee to the network platform operator, which, after keeping a tiny slice for itself, remitted the remainder of the payment to the issuing banks. Those banks in turn used these fees to cover their costs of operating the interchange system and recruiting the customers that the retailers needed to make the system work. Under market conditions, those interchange fees were about 1.35 percent of a debit card transaction amount, which worked out to about forty-seven cents on the average $35 transaction.
Passed in response to intense pressures from retailers, the Durbin Amendment limits the fees that the issuing banks can collect from retailers and merchants to only the “incremental costs” specifically tied to the “authorization, clearance, or settlement fees of a particular electronic transaction.” The legislation explicitly excludes all “other costs” that are necessary to keep the debit card system in operation. The Durbin Amendment also provides that each retail merchant should have two pathways to execute the transaction, so that they do not have to rely on the two dominant platform operators, Visa and MasterCard, for that service.
Judge Leon’s decision, if it goes into effect, will slash these debit card fees below the 21 cents-per-transaction rate that the Fed allowed in 2011, which was less than the pre-Durbin debit card fee of 47 cents on the ordinary $35 transaction. Judge Leon’s interpretation cuts fees to somewhere $0.06 and $0.03 per transaction, while simultaneously imposing on the platform operators costly obligations to redesign their basic system, with money that will have to come from some other source.
Debit Card Success Story
The debit card experienced rapid growth after it hit the market in the mid-1990s. By 2008, it had surpassed the once dominant credit card both in the number and dollars of transactions. The principle behind that card was simple. The individual debit cardholder tapped into an existing bank account in order to pay routine bills. The use of the card puts the brakes on large expenditures that people cannot afford—expenditures that could prove harmful to people of limited means.
The debit card transaction also supplies the merchant with accurate information on both cash and merchandise. It increases, through so-called “ticket uplift,” the amount spent on typical restaurant meals or retail services. It reduces the risk of theft associated with cash, and eliminates the risk of bad checks through the issuing bank’s guarantee to the retail merchant.
All of these advantages do not come for free, but must be serviced by a set of fees to cover the full costs of operation. Some of those costs include the expense of designing, setting up, maintaining, and improving a debit interchange system—and the extensive costs of luring customers to use their debit cards.
The large interchange fee was intended to overcome this fundamental problem in what are called two-sided markets. No customer will bother to carry a debit card if stores will not honor them. Stores will not accept these cards unless customers will use them in large numbers. Customers—especially the lower-middle class customers attracted to debit cards—are far more sensitive to price changes than the retailers who sit on the other side of the transaction.
Accordingly, the rational strategy in two-sided markets is for the retailers to offer a subsidy to induce the customers into the system. The debit interchange fee supplied that subsidy by allowing the banks to offer the basic debit card service for free. The only reason this system flourished was that it left all parties, including the retailers, better off.
Despite their good fortune, retailers started complaining about the Fed’s regulations. They claimed that they entered the system only because they could not stay out of it once their competitors got involved—which is an unkind way of saying that they benefited from the deal. The retailers then backed up their lament with the bogus claim that this market was infected by the monopoly power that Visa and MasterCard brought to the table. If that were true, then it should also be true of credit card transactions, which are not subject to any direct regulation.
The retailers’ charge does not make sense for another reason: the network operators keep only a tiny slice of the overall interchange fee, the rest of which goes to system upkeep and recruitment efforts. Why would merchants move heaven and earth to create monopoly profits for the many issuing banks to whom they pay over most of the fees? Nor do merchants explain why they can continue to do business with banks that have under $10 billion in assets, who were excluded from the law by an ad hoc compromise used to get community banks to accept the Durbin Amendment.
The retailers behind the Durbin Amendment have argued unconvincingly that the legislation generates costs savings that could be passed back to their customers. These individuals are, however, the very same individuals who now have to pay increased fees to their issuing banks in order to keep their cards. They hardly care whether the money comes out of one pocket or the other. What they want is to incur the lowest total costs as buyers and debit card holders, which is what the old market system accomplished—and the Durbin Amendment does not.
Administrative Deference and Constitutional Oversight
The Durbin Amendment charges the Federal Reserve with implementing the regulation. During 2010 and 2011, it conducted an extensive fact-finding investigation. Its initial determination was to allow the banks to recover up to $0.12 per transaction if they could prove their costs, subject to a minimum guarantee of 7 cents per transaction. That action sent a deep tremor through the banking industry, which had to face a 75-85 percent cut in the $16 billion in interchange fees that the system had generated in 2009.
The Fed took heed of the complaints and decided to raise the rate up to $0.21 by including some direct system costs for upkeep and operations. That revised rate still left the industry to cope with a 55 percent rate cut. The Fed and the banks were confident that this fix would stick, because of the standard rule that, on technical matters, courts defer to the interpretation that an administrative agency puts on its own statute.
But the catch to this so-called rule of “Chevron” deference—named for the 1984 Supreme Court case that announced it—is that it only applies when the statutory meaning is not clear. However unsavory the retailers’ economic agenda, they drafted a very clear statute, just as Judge Leon concluded. The legislation divides expenses that “shall be” allowed and those that “shall not be allowed.” There is no third class, which means that if the statute is good law, the regulations are bad law. End of story.
Or is it? Back in 2010, I worked for a time as a legal consultant with TCF National Bank, which mounted a failed constitutional challenge to the Durbin Amendment. TCF had claimed correctly that the legislation was confiscatory of the capital that the large banks had invested in their systems. That challenge foundered on the ground that the large banks could not claim that they were stripped of their wealth, given that they still could offset their losses through direct fees to their customers.
That claim was always spurious. It was in fact a moral certainty that going forward the banks could not recover all their lost fees from a customer base that, to date, had contributed exactly zero to the bottom line. Indeed when major banks, like Bank of America and Wells-Fargo, tried to implement these user fees, Dick Durbin chastised them for driving away their own customers. No fees were collected from customers that were tied to their debit card use.
Reasoning for Second Challenge
At this point, the question is whether to mount a second constitutional challenge in response to the latest developments. The other alternatives are really grim. Success on appeal looks slim because Judge Leon’s greatest sin was to give an accurate reading to a perverse statute. I would glumly vote to affirm the decision if the only grounds for appeal related to his statutory reading. Going back to the Fed will get no relief, and even the sensible compromise position of asking Congress to ratify the Fed’s $0.21 rate is likely to fall before Senator Durbin’s wrath.
So why not renew the constitutional challenge? For one thing, it gives a chance to expose the mistakes of the earlier constitutional decision. Even if the Durbin Amendment was an effort to respond to a (nonexistent) monopoly, it is not constitutionally allowed to cut rates so deep that a firm cannot recover the full costs of running its operations. In 2011, there was some sense that revenues from debit cardholders could fill in the gaps. But we now know for certain that the revenues raised from that source were exactly zero, and that banks have suffered huge capital losses from the Durbin decision.
Those losses will only mount further once the rates are slashed yet again and the network routing has to be redone. The whole scheme looks from start to finish to be a huge wealth transfer to retailers from the customers whom they profess to serve and the banks with whom they deal. Judge Leon’s decision may be correct under the statute, but the statute is incorrect under the Constitution. It is time for the Supreme Court to stop the senseless damage from Dick Durbin’s favorite amendment.
Richard A. Epstein ([email protected]) is the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution, the Laurence A. Tisch Professor of Law at New York University Law School, and a senior lecturer at the University of Chicago. Used with permission of Defining Ideas, a journal of the Hoover Institution.