Continuing our series on the Durbin Amendment, we talked to Professor Bill Longbrake of the University of Maryland. He, along with Dr. Clifford Rossi, published a paper in March of this year that predicted the effects of, and made a strong case against, interchange regulation.
A number of the Durbin Amendment’s supporters (as well as we Durbin-agnostic nerds) believe that the interchange market is inefficient. We believe that the lack of competition in the processing market – Visa and MasterCard together account for about 80% of all transactions – has led to an artificially high interchange rate, which is a particular burden on small retailers.
Longbrake has a different perspective. He bases his analysis on the concept of a two-sided market, where a platform serves two or more distinct groups. For example, a TV station connects advertisers to viewers, an insurance company helps both doctors and patients, and iOS brings Angry Birds to an iPhone.
How is the interchange market two-sided?
In this case, card networks like Visa and MasterCard facilitate an interaction between merchants on one hand and banks on the other. But what about consumers? To an extent, they’re on both sides of the equation. Lower interchange fees mean lower costs for merchants, which in theory mean lower prices for consumers. On the other hand, higher interchange fees mean higher profits for banks, which mean more rewards and free checking.
The latter scenario prevailed before the Durbin Amendment: the merchants paid a high interchange fee, banks made a nice profit and consumers got the benefit of fraud prevention and solid checking programs. This, Longbrake says, was actually instrumental to the spread of debit cards. “Consumers never would have adopted debit cards to the extent that they have if they had to pay a fee in the first place. The interchange pricing system was critical to broad acceptance, which greatly improved the efficiency of payment systems, which in turn decreases costs collectively to society.”
“At first blush it would appear that banks were benefitting unfairly, which is the argument that Durbin and his supporters made in support of swipe fee regulation,” says Longbrake. “Consumers [used] debit cards because they were convenient and they paid no fee. Merchants benefitted from reductions in fraud, and evidence indicates that merchants who accept debit cards benefit from higher average dollar sales amounts per transaction.”
So what happens when government intervenes in an already-efficient market?
Longbrake argues that the Durbin Amendment is based on the assumption that in an unregulated market, banks win and merchants unfairly lose. But that assumption leaves out a key player: consumers. Now that the Durbin Amendment has been implemented, merchants benefit at the expense of banks (of course) and consumers (who pay higher debit fees). As a result, consumers lose their incentive to use debit cards, which in turn hurts merchants because people spend more when they pay with debit cards than if they pay with cash. “The swipe fee regulation on balance will have negative consequences,” he concludes.
In his opinion, an interchange fee didn’t represent just fraud prevention costs plus big bank greed. It also represented rewards and free checking, which indirectly benefitted merchants in that they incentivized consumers to use debit cards and thus to spend more. Longbrake argues that the Durbin Amendment upsets this carefully balanced ecosystem.
“Because the swipe fee regulation set the maximum fee below the level necessary to cover costs, it was inevitable that consumer services would be curtailed and debit fee charges would be imposed,” he says. “It is simply a matter that no business can provide a costly service at a loss and expect to stay in business. Consumers will end up paying more, and because the service is now explicitly priced, some will use less costly means of payment such as paper checks or credit cards.”
And he believes that small businesses will hurt the most: “Smaller merchants are more susceptible to a reduction in consumer spending behavior. While the redistributive effects of a cap on debit interchange fees may benefit merchants on average, it could result in negative consequences for small business due to consumers’ reaction to higher debit fees and poorer services. A specific concern is higher fraud losses for small business, which are less well equipped to deal with fraudulent activity.”
So how’s his track record?
So far, Professor Longbrake has accurately predicted the fallout from the Durbin Amendment: higher fees, lower rewards, and a shift from debit to other types of payment. And just as he foresaw, merchants are benefitting, banks are hurting and consumers pay higher fees but have yet to see the benefit of lower prices.
We’re not sure we agree with everything Professor Longbrake has put forth; in particular, we believe that consumers suffer from a lack of security innovation because card networks have little incentive to improve their security practices. In Europe, where interchange fees have come under heavy fire, the more effective EMV chips are common, but in the states, the fraud-prone stripe and signature verification method is still used.
Still, we can’t deny that most underestimated Durbin’s effect on consumers. Chase kicked off the push from debit by ending its rewards program, and while Bank of America’s gotten the most attention for its debit usage fee, many other banks have quietly done away with free checking. As a result, many consumers are choosing alternatives to debit, be that banking at a credit union or simply using credit cards and cash.
As we continue to showcase different perspectives on financial regulation, please email [email protected] if you’d like to contribute an opinion piece or give an interview.