Chicken Little’s Loopy Logic

Opinion & Analysis

Steve Mott

Banks and card networks argue Durbin and other recent regulation will hurt small banks and consumers. But take heart, the sky will remain firmly in place.

The cries of anguish from the banking industry and from the payments players that live off banking’s traditional revenue largesse would have most observers outside the business thinking that the sky is falling.

New regulations mandated by Congress will gut the debit card business at the expense of consumers and to the benefit of undeserving merchants, the banking chorus chants.

Those regulations, which implement the Durbin Amendment to the Dodd-Frank Wall Street reform law enacted last summer, were due in final form this month, and that may well have happened by the time you read this.

Or not. Led by aggressive national lobbying from Visa Inc., those who have benefited from the status quo in retail payments are pulling out all the stops to derail, or at least slow down, the Durbin Amendment. Durbin is expected to take effect in July, but even this may be deferred. This legislation instructed the Federal Reserve Board to lower debit card interchange rates and correct other perceived competitive anomalies in the debit card business.

According to many of the comments solicited by the Fed following its Dec. 16, 2010, announcement of proposed rulemakings, consumers—who were supposed to be the primary beneficiaries of the legislation—will suffer in many ways from the proposed 75% cut in issuer interchange.

Other banking services, such as free checking and rewards programs, will have to go, and other fees increased, these comments said, so that everyone involved in payments can remain whole on the revenues they normally make.

“The Board’s December 16, 2010, proposal would, if implemented, impose direct, immediate, and certain harm on consumers, especially lower-income consumers, and small businesses that use checking accounts,” declared David S. Evans, Robert E. Litan, and Richard Schmalensee, economists and principals of Market Platform Dynamics, a bank consulting firm, in one comment. “To offset these lost revenues, banks and credit unions will increase fees to their retail customers for checking accounts, for the debit cards that are usually provided with their accounts, and for other retail banking services.”

Then there was this from the authors of a related paper (which received substantial funding and data from the Electronic Payments Coalition, a banking-industry lobbying group): “These harms to consumers and small businesses will not be offset significantly by merchants charging lower prices for goods and services as a result of lower interchange fees…In fact, if implemented, the effects of the Board’s proposal on merchant prices will occur slowly, and the amount of future reductions in retail prices is uncertain.”

But here’s a thesis that hasn’t received much attention, either in the Fed comments or anywhere else: What if the Durbin reform to the debit card system is just the medicine the debit card business—and retail banking in general—needs to re-make itself into an industry that is more relevant and more balanced in the value it brings to its participants?

And wouldn’t American society be better off if all those financial institutions didn’t need to make all their precious revenues?

Apocalyptic Outcomes?

At this writing, it’s hard to predict how the final Fed rules will turn out. Suffice it to say the revenues at risk are substantial, regardless where the Fed comes down on its interchange caps. It’s only a matter of degree.

Just going with the proposal on the table, debit card issuers face a $21 billion estimated loss of annual revenue from the recent wave of legislative initiatives. This includes an estimated reduction of about $14 billion in debit card interchange from the Fed’s proposed rates, plus another $7 billion in reduced insufficient-funds (NSF) fees on signature-debit cards as a result of recent overdraft-fee legislation, which requires banks to get consumers to opt-in for overdraft protection.

But this potential loss of revenue, substantial though it may be, will not give rise to the apocalyptic outcomes predicted by the banking lobby. What follows are 10 issues where the polemics have overruled all reason in the public debate over Durbin. The first half dozen deal with the potential victims, or beneficiaries (depending on your point of view), if the Fed’s proposed rule-makings remain largely intact.

For each issue, I present the banking lobby’s argument, then counter that with a point of view you may not have encountered because it was drowned out in the debate.

1.The legislation transfers wealth from banks to merchants.

Conventional Wisdom (CW): Monies heretofore earned by banks will now be pocketed by merchants, with little likelihood of them trickling down to consumers in the form of lower prices. This amounts to confiscation, with no guarantee that consumers will benefit.

Contrarian View (CV): Interesting that this argument surfaces now, since there was essentially a transfer of wealth from both merchants (signature-debit card interchange and fraud costs) and consumers (NSF fees for overdrafts) in the other direction for 20 years—to the tune of tens of billions of dollars a year.

Merchants operate on a far more competitive basis than banks, so long term, consumers (and we are all consumers ultimately) should benefit from a reduction in an unproductive cost of doing business.

2. The nation’s 16,500 financial institutions will be financially crippled.

CW: At a time when banks are reeling from economic reversals (albeit of their own doing), the Durbin impacts will throttle their recovery. According to the Fed surveys submitted last fall, some 20% of banks will be under water with respect to their debit card operations at the Fed’s proposed 7-to-12-cent caps, and many more might not be able to continue to offer these cards. Some may have to cut back jobs. The proposed rates simply don’t cover the fixed costs of operations.

CV: Higher-cost banks will be forced to make hard, but necessary, decisions about sustaining their infrastructure—just like most other businesses do. Most small banks have relatively small absolute revenues from debit cards, as the big banks dominate this business already. And does the nation need to support the fixed costs of 16,500 separate financial institutions?

3. The $10 billion asset exemption to protect small financial institutions won’t work.

CW: Durbin exempts from price regulation financial institutions under $10 billion in assets. The idea was to let market forces allow for pricing differences to exist, so smaller banks and credit unions could charge higher rates than the big banks do if they needed to. Big, sophisticated merchants could push for use of low-rated debit card network options, effectively making the exemption worthless—even if it could be implemented.

CV: Is it workable? You could probably make it work online, with a host-based service (like Acculynk Inc. for PIN-debit cards). Offline, the lack of real competition and demand-based pricing, needs to be rectified with a more flexible, open infrastructure anyway.

But the fears of bigger merchants snuffing out use of small-bank and credit union cards with higher rates seems more imagined than real. Even if they could identify higher-cost network cards (or card options) in real-time, they would have to train their checkout staff to press consumers to change their payment options, and perhaps their preferences, at the risk of losing the transaction—something they are loath to do.

4. Acquirers might get a windfall initially, but will get squeezed by pricing pressures.

CW: For the past 15 to 20 years, the acquiring/processing side of the business has endured steady price compression of 1% to 3% per year, and acquirers get only about 20% to 25% of the total merchant discount fee. In other countries, the issuer-acquirer fee split is more like 50-50—reflecting the realization that acquirers do most of the heavy lifting for processing, and deserve a higher cut.

So acquirers might be tempted to try to pocket the interchange savings, just like they pass along fees from Visa and MasterCard to the merchants.

CV: A lot of people have made the Fed and Congress aware that acquirers might try to profit from the circumstances if they can, but all rates are under a microscope now, so gains are unlikely. And, it won’t hurt that the nation’s acquirers will be compelled by the new economics (and requirement to offer more competitive options) to update their aging systems.

5. Independent sales organizations might either benefit unjustly or, more likely, become victims.

CW: ISOs will be tempted to pocket the interchange-rate reductions with merchants that aren’t paying attention.

CV: It won’t take long, in these media-charged times, for even the smallest and most ignorant merchant to figure out that payments costs ought to be going down. Most ISOs are warning they will be forced into layoffs—again, raising the red flag of job losses (obviously hoping the recovery-minded Congress will relent).

6. The big merchants will  benefit undeservedly.

CW: Merchants don’t want to pay for the costs (and inherent value) of payment card acceptance, and whine and complain endlessly about it. Bigger merchants will figure out how to route transactions to the lowest-cost networks, while smaller merchants will simply pass their higher payment costs on to consumers.

CV: The advantage card acceptance once offered merchants—that it gained new business—largely disappeared many years ago. For most merchants, it is just an unproductive cost of (and requirement for) doing business. Most of them say they will pass along cost savings in their normal course of doing business.

The Real Stakes

The next four issues deal with intended beneficiaries of the Dodd-Frank (and overdraft and credit card reform) legislation. Here again, the industry fears the worst.

Late in February, the Independent Community Bankers Association (ICBA) reported the results of 1,110 responses (from a survey sent to its 5,000 members), noting visceral responses of gloom-and-doom over Durbin:

– 72% percent of respondents said they would have to implement annual or monthly charges for debit card use;

– 61% said they would have to impose minimum-balance requirements;

– 50% said they would have to impose a debit card transaction charge;

 -65% said they would need to either raise debit card qualification standards or close higher-risk accounts;

 -Not quite 20% said they might even eliminate jobs or close branches;

 -72% said they would no longer be able to afford to offer free checking;

 -Nearly 70% said they would have to charge for such currently free services as online or mobile banking.

“This survey confirms what we community bankers already knew, that implementing this deeply flawed proposed rule will hurt our Main Street customers because merchant costs associated with debit card acceptance will shift to consumers and small businesses,” ICBA chief executive Camden R. Fine said in the association’s press release.

Let’s look at these consumer issues a little more critically:

7. Free checking accounts will disappear and debit account fees will proliferate.

CW: Free checking will likely fade away for less qualified customers with low balances and deposits. Fees on “lazy” debit accounts will almost certainly go up. And some higher-risk accounts could well go by the wayside, as banks can no longer afford to give these services away.  

CV: What’s wrong with that? Sounds like responsible banking. And since late last year, there has been a proliferation of advertising campaigns launching new free-checking programs—particularly for small-business accounts. Why should merchants pay the costs of banks competing with one another to provide less-qualified consumers with free checking account services?

8. Consumer and small-business debit card rewards programs will dry up.

CW: No doubt. Led by JPMorgan Chase & Co., the industry has indicated it will curtail many debit card rewards programs.

CV: Very few of the hundreds of bank card rewards programs developed over the past decade (and just about none of the so-called innovations the industry says will be suppressed by Durbin’s mandates) could be termed effective—even for the issuers that marketed them. Why does it make sense for merchants to pay the costs of one issuer succeeding over another?

9. The government is trying to force unusable PIN debit down consumers’ throats.

CW: Signature-debit card transactions cost at least twice as much as PIN debit, and the proposed rates won’t cover those costs. Worse, PIN debit is only accepted at a third of the merchant locations that take sig-debit cards. And PIN debit won’t work online, or for split orders or T&E or other payments. So consumer convenience will suffer in many ways.

CV: For decades, consumers (and merchants) have consistently preferred PIN debit as the safest and most effective way to pay. Banking interests, on the other hand, did everything possible to discourage its use, in order to promote higher-revenue sig-debit cards.

Here’s the new reality: PIN debit works fine online; the business case for point-of-sale merchant acceptance is suddenly much better at reasonable, cost-based rates; and PIN-debit solutions exist for nearly any payment application—if allowed to compete without unfair suppression.

10. Lower remuneration and merchant choice on networks will raise fraud risks.

CW: Banks of all sizes complain that the 7-to-12-cent interchange limits won’t cover the costs of preventing fraud. Worse, Visa said in its comments that letting merchants choose networks could disadvantage consumers, as some debit card networks offer inferior protections.

CV: These claims seem somewhat suspect for an industry that writes off tens of billions in bank card chargeoffs every year on bad credit risks, and where the signature-debit card option it prefers experiences eight to 10 times as much fraud as good old PIN debit.

Summing up, it is certainly true that a lot of consumers will get a lot fewer subsidies that were financed by merchant interchange. People and products will have to pay their own way under the new paradigm. But all consumers are a lot more likely to get access to a truly better means of accessing their money left to banks for safekeeping—safe, efficient PIN debit.

So the real stakes on the debit card industry’s table appear to be much higher than the $21 billion a year it stands to lose under recent legislation. That’s because the Durbin mandates address many aspects of necessary and true reform of the bank-payments business.

For an industry used to getting its way in Congress—more often than not with the same Chicken Little approach it’s using today—Durbin is viewed as Armageddon. But for the primary users of the payments system—consumers and merchants—this legislation might be just what the doctor ordered.

 

Steve Mott is principal of BetterBuyDesign, a payments consultancy based in Stamford, Conn. Reach him at stevemottusa@yahoo.com.