The Durbin Amendment Explained

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The Durbin Amendment, a last-minute addition to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, has sparked fierce debate about government regulation, consumer choice, innovation and entrepreneurship. The bill drastically lowers swipe fees – the fee charged to merchants every time a customer pays with plastic – on debit cards issued by big banks, cutting into the banks’ revenue while, presumably, lowering costs for merchants and therefore consumers.

Update 9/26/12 – throwing the gauntlet: The American Bankers Association sent a letter  on 9/20 to the congressional leadership urging them not to regulate interchange fees further, repeating the “mistakes” of the Durbin Amendment.

The consequences of the so-called Durbin Amendment to the Dodd Frank Act (imposing price
controls on debit card transactions) are instructive…an increase in profits at big-box retailers, higher costs to
merchants, significant reductions in the revenue available to banks to serve local communities, and
no sign of the lower retail prices consumers were promised. We do not believe it is in the interest of policymakers or the consumers they represent to repeat the mistakes of the past.

Durbin didn’t take this lying down. On 9/25, he shot back: “While the banking industry may resent that its enormous lobbying effort did not produce a different outcome, a defeat is not the same as a mistake.”

In the end, it’ll matter what Congress and regulators think. If they consider the amendment a success, we may see further interchange regulation; if not, the regulations may be rolled back.

Though the Durbin interchange amendment only began to take effect on October 1st, 2011, we’re already seeing its ramifications. Banks have priced lower swipe fees into their checking offerings – that means we’re seeing less and less free or rewards checking. And since prepaid debit cards aren’t covered by Durbin, we’re seeing an explosion of those products. On the other hand, retailers have yet to lower their prices as promised, perhaps because Visa and MasterCard jacked up their rates on small merchants. One thing is certain, however: big bank checking customers are not happy.


Definition: What is the Durbin Amendment?

When you use your debit, credit or prepaid card at a store, the merchant has to pay an interchange, or “swipe,” fee. The fees vary in proportion to perceived security risk, based on:

  • The card used: Debit cards have the lowest interchange fees, while high-limit signature rewards cards have the highest.
  • The method of payment: Card-not-present transactions (like buying online) have high fees, while PIN transactions have low fees.
  • The type of merchant: Gas stations, small restaurants and small business owners pay the highest fees, while big box retailers like Walmart and Safeway are able to negotiate lower prices.

The interchange fee is supposed to cover the risk of fraud, transactional costs, and other overhead, but due to the lack of negotiating power on the merchant side, it’s now a major source of profit at every bank that offers checking accounts. Subsequently, competition between banks has caused this profit center to be used in subsidizing premium services, like free checking accounts and surcharge-free ATMs, and using credit card rewards to incentivize usage. For this reason, now that swipe fees are lowered, we see banks charge more and more for those services.

Supporters of the Durbin Amendment contend that this opaque pricing system unfairly burdens small merchants and the poor. Interchange fees take up an outsize portion of small business’ budgets, and before Durbin, they were not allowed to offer discounts for cash or enforce credit card minimums. The poor are less likely to see perks like credit card rewards, but still pay more to cover the merchants’ higher costs. Durbin sought to address these problems.

The amendment had two major goals: to introduce competition into the debit processing network, and to cap swipe fees just in case competition didn’t lower prices.It explicitly exempts financial institutions with less than $10 billion in assets, a designation that includes most community and state banks, and all but three credit unions, and will be implemented in full in 2013.

Among the quickly implemented, less controversial provisions:

  1. Merchants can impose a $10 minimum on credit card transactions (this number can be adjusted by the Fed as they see fit). Previously, Visa and MasterCard banned this practice in their merchant agreements.
  2. Merchants are allowed to give discounts at the register to those who pay with cash or debit cards. Previously, Visa and MasterCard banned this practice in their merchant agreements.

More divisive were the interchange fee cap and “network exclusivity” provisions. In the legislation, the Federal Reserve was directed to:

  1. Cap debit interchange fees at a reasonable rate that would still cover fraud protection costs, and
  2. Eliminate requirements that debit cards be processed on only one network.

The Federal Reserve initially considered a 7 to 12-cent fee cap, and a requirement that each debit be able to be processed on two independent networks for each method of verification – two for PIN, and two for signature. But after the Durbin Amendment barely survived a challenge from Sen. Jon Tester, the Federal Reserve issued its final ruling on June 29th, 2011. The Fed’s interpretation of the Durbin Amendment is generally seen as more favorable to the financial industry than expected. For a complete rundown, check out our analysis of the Fed’s final ruling.

  1. Debit card interchange rates are capped at 21 cents plus 0.05% of the transaction, with the possibility of an additional cent if certain security criteria are met.
  2. Each network must be able to be processed on two independent networks, one for signature debit and one for PIN.

The Fed capped debit interchange fees at 21 cents plus 0.05% of the transaction, with the possibility of an additional cent if certain criteria are met. Each debit card should be able to be processed on at least two independent networks, and the rules will begin to take effect in October. This ruling is generally seen as more favorable to the financial industry than expected.

The Visa-MasterCard Duopoly

Proponents of the amendment allege that merchant interchange fees have skyrocketed relative to the cost of processing the transactions. The interchange market is largely uncompetitive: Visa and MasterCard effectively set the interchange fees for all merchants. Merchants can choose not to accept Visa and MasterCard, but this is not practical for most. The Durbin amendment’s attempt to reduce prices is two-pronged: first, the mandatory introduction of competition, and second, a limit to fees in order to correct for the market failure resulting from what is essentially a duopoly.

U.S. swipe fees are, overall, uncompetitive when compared to European countries, where anti-trust regulation has broken the chokehold of Visa and MasterCard. U.S. debit interchange fees are higher than the European Union average but not egregiously so; the true effect of uncompetitive pricing is seen in the interchange fees charged on credit card transactions, where the U.S. is by far the highest.

Most notably, the fees on some premium credit cards diverged greatly from the rest of the industry in conjunction with the 2007 IPO’s of both Visa and Mastercard, likely because of pressure to juice profits for public shareholders:

Bank and credit union opposition

Banks are, of course, against the amendment, because debit card swipe fees mostly accrue to the financial institution that issued the debit card. Card issuing banks typically took in about 1.3% of every dollar you spend on your debit card as a fee from the merchant. This amounts to nearly $3 billion a year of very high profit margin revenue for Bank of America, for example, and the Fed’s final ruling is expected to cost the industry more than $6 billion. Credit unions also opposed the amendment, fearful that they would also lose interchange revenue despite the small bank exemption.

The swipe fee cap technically exempts financial institutions with assets of $10 billion or less. In theory, this applies to all but 3 out of the 7,000+ credit unions. However, credit unions are aggressively lobbying against the amendment. They fear that the provision requiring multiple network routing options will make the small bank interchange cap exemption impossible to enforce. For example, Visa already promised to honor the two-tier pricing system, and would process a small institution’s transaction at the current price. However, the networks are not required to differentiate between large and small banks. Even if Visa’s STAR network offered to route a debit transaction at the “exempt” 1.5% debit interchange rate, the existence of a competitive option allows the merchant to route the transaction through NYCE instead for 12 cents.  Therefore the credit union would receive some fraction of 12 cents for the transaction, rather than ~1.3% of the transaction.
In the end, however, Durbin was a blessing for credit unions. As non-exempt banks cut back on free and rewards checking, credit unions capitalized on customers’ ire to draw them into free checking accounts. Bank of America blames its short-lived $5 debit card fee on the Durbin Amendment; that action was the catalyst for Bank Transfer Day, which brought new attention and new customers to credit unions.

Durbin ignores high credit card fees

Because of the difficulty of differentiating prices for goods based on the method of payment, merchants generally factor the exchange fees into the sticker price, or absorb the cost themselves. As a result, whether a consumer pays with cash, debit, credit or rewards credit, he will see the same price (one exception is in gas prices, where the limited number of products offered allows for price differentiation). However, merchant exchange fees for credit cards, and rewards credit cards in particular, are significantly steeper than debit card fees.

One feature of monopoly pricing is that the card network can, as much as they are able, set different prices to maximize how much it believes different groups will pay. So, for example, a Visa Signature Preferred rewards card nets a 2.5% interchange fee at a restaurant (which has little bargaining power), while a Visa Classic transaction may cost a large supermarket only 1.15% (because Visa wouldn’t want to risk, say, Wal-Mart walking away). By comparison, in France, a credit card with an embedded security chip costs all merchants 0.22% of the transaction plus 10 Euro cents, while the least secure (and thus most expensive to cover) method of payment costs 0.3% plus 10 Euro cents (there is virtually no difference by way of fees with Visa versus MasterCard). The intricacies of pricing, and the emphasis on the lucrative, oft-used credit card rewards, speak to market inefficiencies.

Are the fees necessary to fund fraud protection?

The major card networks allege that the interchange fees are necessary for fraud protection efforts, and to limit consumers’ losses in case fraud does occur. However, improving technology should have driven down the cost of fraud protection, not increased it. Jamie Henry, Wal-Mart’s director of payment services, argued that credit card issuers have deliberately kept chip-and-PIN technology from U.S. cards because security improvements would remove the justification for high merchant exchange fees. “Lower interchange would push the industry toward chip-and-PIN. We would see more financial institutions become interested in controlling fraud. It would be more difficult to pass [fraud] costs on to merchants.”

In response to proposed regulation, banks cry foul and threaten tightened credit, higher fees and steeper interest rates should the proposed regulations take effect. Some have also threatened per-transaction spending caps on debit cards, at $50 or $100, rendering debit effectively useless in paying for groceries, restaurants, or plane tickets, and driving customers toward more lucrative credit cards.

The rationale behind swipe fee caps

The Federal Reserve believes that merchant exchange fees far exceed the cost of fraud protection. They further believe that the steep markups persist because the two major card networks, Visa and MasterCard, have such control over the credit and debit card markets that merchants, card issuers and consumers have no choice but to accept the prices that they set.

In order to correct this, the Fed proposed a cap that it believes accurately reflects the true cost of securing the debit cards used. If they have correctly judged the cap, banks will not suffer a loss to their bottom line, and will continue to provide the same services to consumers while merchants are able to offer better prices. They also introduce competition to previously monopolistic markets by requiring each debit card to be covered by at least two networks. However, the amendment fails to address credit card interchange fees, which are significantly higher than debit.

Although the regulations make an exception for small institutions, this exemption is meaningless as card issuers will have to accept the lowest exchange fee offered, whether or not it covers their security costs. This is an undue burden on credit unions, which are generally smaller and pay more to protect their customers.

This is not to say that the “swipe” fees are grossly overpriced, and that government reform of the market will not benefit consumers. However, the Federal Reserve must be careful to preserve the advantages offered by credit unions.

The following infographic, which we released last April, gives further details about how interchange fees affect merchants and banks.

Infographic: What does the Durbin Amendment mean for you?

Durbin Amendment Infographic

  • Jonathan

    Given that Visa, MC, and most others have rewards tiers, is that outside of the tiered vs. interchange+ argument? I know we are talking about processors here, but are actual card networks allowed to charge higher interchange on their ‘premium’ tiers vs. lower tiers (Visa traditional vs. signature)? Or do they all charge the same interchange regardless of tier?

  • Dax Bermudez

    This article is full of errors and omissions. For example, STAR is not owned by Visa, it is owned by First Data, one of the largest acquirers in the US. Interchange fees are not set by the payment networks, Visa and MasterCard, interchange fees are actually set by the card issuers. Visa and MasterCard are responsible for settling the interchange fees between the issuer and acquirer.

    • Rob Leighton

      I worked for both Visa and MC, they set the interchange rates.