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Interchange Amendment Passes Senate 64-33

posted by Adam Levitin

Interchange legislation is on the move.  An  amendment the Restoring American Financial Stability Act of 2010, sponsored by Senator Durbin passed the Senate on a roll-call vote of 64-33.  The amendment instructs the Federal Reserve to regulate debit interchange fees and requires that the fees be reasonable and proportional to the costs of the issuer or the payment network.  The amendment also restricts certain merchant restraint rules for credit and debit payments.  It prohibits restrictions on minimum and maximum transaction amounts for credit and debit, and it prohibits restrictions on merchants offering discounts to steer transactions among networks or to other forms of payment (the existing Cash Discount Act does not clearly protect debit discounting, for example, and the card networks' rules largely frustrate discounting as it is). 

The amendment doesn't address all of the problems with interchange, and I would have preferred to see surcharging, rather than discounting, but it's a very good start (and I think arguably the Fed could permit surcharging as part of regulations implementing the amendment).  Of particular importance is that (if the amendment becomes law) a federal regulatory agency is now clearly vested with authority to regulate interchange, and that reasonable and proportional is set as the standard for the level of the fees.  That's a major change from the current situation in which interchange is beyond the regulatory sphere.  To be sure, there's no analogous provision in the House bill, which raises an issue for conference, if the Senate bill passes, but this is a major step forward on fixing the interchange market. 

Comments

Adam you continue to tout interchange regulation as somehow good for the consumer when it has been shown empirically to have the opposite effect.

What do we know from the failed Australian experiment in interchange regulation:
1. Annual Fees increased for consumers
2. Rewards for consumers went down
3. Merchant profitability went up
4. And most importantly, there has been NO anecdotal or empirical evidence to sustain the idea that prices have fallen as a result of interchange regulation

I would point you too the Charles River Associate study and while commissioned from within the payments industry is a methodical and well-sourced rebuttal to the RBA's contention that somehow interchange regulation was good for the consumer.

http://www.crai.com/ecp/assets/Regulatory_Intervention.pdf

Given this is all on the heels of CARD Act and the worst loss environment since the early 80's, it is very likely if this comes to fruition, it will put the card industry into a complete tail spin and it won't be just lower profits there will be a massive constriction in credit both for low and high FICO scoring cardholders as issuers leave large swaths of the business.

"it will put the card industry into a complete tail spin and it won't be just lower profits there will be a massive constriction in credit both for low and high FICO scoring cardholders as issuers leave large swaths of the business."

And this is bad? The changes you note would cause consumers to use less credit, and this is a GOOD thing. Have you seen the bankruptcy and default statistics lately? There's TOO MUCH credit available; reducing it is not really a problem. People would have to go back to living within their means. Oh Noes! !Eleventy! Were conditions really so harsh in the days before everyone could so easily go into debt up to their eyeballs? Why are half the ads on TV for credit remediation services?

The credit card industry is a leech on society; it only exists to enrich itself while turning its users into indentured servants. Making it smaller would be a big step to returning to a healthier society.

Guys, why are you discussing the credit card industry when the amendment regards DEBIT interchange? Hangtime is correct about the effects of this type of legislation in Australia, but that legislation took explicit aim at CREDIT, and was in fact specifically designed to encourage people to use MORE DEBIT (which provided a cheap alternative in Australia because of the EFTPOS system).

This legislation will mean that banks make less money off debit interchange, which from a societal point of view is already the cheapest form of widespread electronic payment (but of course could still be cheaper). In response, the banks will just raise fees somewhere else -- if they don't get 7 cents every time you go to the grocery store, they will take $5 when you go to the ATM. Debit is especially prone to this kind of gouging because no one chooses their debit card, the bank just hands it out to you.

Hangtime:

If you think it's been "shown empirically" that interchange regulation harms consumers, then I'm guessing you also think it's been empirically proven that there's an Easter Bunny.

Interchange regulation is a pretty clear benefit for overall consumer welfare. There are a lot of problems with your argument. The ones that immediately come to mind are:

First, you conceive of social welfare as credit card network welfare. It ain't. Interchange/Rewards/Merchant Restraints induces higher levels of credit card usage and that inevitably leads to higher levels of leverage. Unless you think inefficiently high consumer leverage is a social good, it's hard to see the current interchange system as benefiting anyone except card networks members.

Second, and relatedly, rewards programs really aren't much of a social good. They are generally of very little value, and if they were taxed as income, as they properly should be, they'd be next to worthless. Whatever benefit consumers get from rewards is offset by the distortion they cause in consumption.

Third, interchange perverts underwriting standards, leading to less safe/sound financial institutions.

Fourth, no one knows whether or not prices have fallen. But that's not proof of regulation failing. Prices could simply have inflated at a slower rate. Again, an unknown, but not a knock on regulation.

Fifth, no one knows if merchant profitability went up or if that change related to interchange. Ultimately it's irrelevant. How the surplus is split between merchants and consumers is a question of the competitiveness of particular consumer goods/services markets. But both merchants and consumers have a superior claim to the surplus than the card networks.

Sixth, MC/Visa/Amex haven't stopped doing business in Australia, nor have any Australian banks failed. They might or might not be less profitable (we don't know), but there's no right to profitability, regardless of antitrust laws.

Finally, the Charles River Associates study doesn't impress. It's funded by MasterCard. I've yet to see anyone not getting $$$ from the card industry give an out-and-out defense of the current interchange system. Beyond this, however, the Charles River Associates study only looks at rewards and annual fees; it doesn't look at interest rates, for example. There isn't great data on Australian card market interest rates, but it appears that rates on nonrewards cards are more competitive now. That's a plus for consumers. It's pretty easy to arrive at the results MasterCard wanted when you focus selectively on certain data.

Australia: the study (sic) indicates that there's no compelling evidence that retail prices declined. That's a lot different from saying there was no impulse in that direction as a result of the Reserve Bank's interention. Do the Charles River people really think that there's no price competition in retail markets generally in Australia (or at least in those accepting payment cards)? ... 'Cause that's seemingly a requirement if you want to claim there's no downward pressure on retail prices as a result of lowering merchants' costs. And, if there's no price competition in those markets, there's a whole lot more of a market failure than simply as regards payment cards. Maybe Charles River is really angling for a much more significant market intervention down under???

First let us set up the problem:

There are two different types of cardholders.
1. Revolvers – Those accounts that do not pay off every month and are financing their purchases over time.
2. Transactors – Those cardholders that pay off their account every month.

“First, you conceive of social welfare as credit card network welfare. It ain't. Interchange/Rewards/Merchant Restraints induces higher levels of credit card usage…”

Rewards systems try to develop loyalty whether you are using your rewards card at Best Buy or redeeming Amex Points. Trying to engender loyalty through offers and rewards for the best customers is a practice as old as business. Of course, rewards are trying to develop higher levels of card usage.

“and that inevitably leads to higher levels of leverage. Unless you think inefficiently high consumer leverage is a social good, it's hard to see the current interchange system as benefiting anyone except card networks members.”

This is a slippery slope argument. In fact, those cards that have the richest rewards have the highest rates but on average are highest turning products therefore the lowest revolving rate cards (revolvers skip these products almost entirely) thus these cards derive a much smaller portion of their profitability from their interest and fees. It is in fact those cards that have lower to average rates where you will typically find the largest revolving balances ($5,000 and up). Lower APR rate cards have smaller or no rewards (and thus lower interchanges) that accompany them. People are on average rational when they choose these cards. If you believe you will revolve on a card there is a good chance you will pick a product that allows you to do so at the lowest cost.

Example: No one applies for an Amex Platinum to revolve (which it does not allow), those cardholders are only for transactors. These Transactors want to be rewarded for their purchase behavior. Where before they would get nothing for spending 30 – 40K a year, now they receive rewards for what they spend. So your argument that only the networks and members of the networks benefit is false. There is very large cardholder population that derives a great deal of benefit from interchange through their rewards.

“Second, and relatedly, rewards programs really aren't much of a social good. They are generally of very little value, “

Let’s rephrase and say how much societal good do rewards programs have. How much societal good is their in carrying around slips of paper that when lost or stolen you have no recourse? To whom do rewards have little value? Are rewards of such little individual value the the Discover cardholder who redeems for a $20 Best Buy gift card should not receive it? The $20 gift card recipient would probably beg to differ. If we are talking societal good, he who rewards and takes care of their customer the best should be the best performing and thus most richly rewarded and respected organization. I think that’s pretty much happened in the payments industry as Amex is continuously the most recognized organization (Note: no I don’t work for Amex). I would argue if you receive anything in terms of rewards both the cardholder and the consumer win.


“and if they were taxed as income, as they properly should be, they'd be next to worthless.”

Why should they be taxed? Your whole argument is that interchange distorts prices. aren’t we all then actually paying a tax already on this benefit that you say is worthless?


“Whatever benefit consumers get from rewards is offset by the distortion they cause in consumption.”

When you go to Vegas you play with chips instead of money. Why? Because all our brains are wired in a way that when you play with anything but cash, fake money, you gamble more. You are not calling out anything here that hasn’t been proven time and again through experiments. However, its not rewards that drive consumption it’s the suspension of reality through the use of fake money not rewards on the card. It would be no different it we were talking about chips, tokens, or peanut shells. The further from cash reality you are, the greater the propensity to spend.

Which brings a few questions:
If credit/debit cards distort consumption higher, why should the retailer pay less for them?

If rewards are little to no value then how do they increase consumption in the first place unless people are totally stupid and don’t understand the value of points? If you believe this to be the case then I can point you to a number of websites (FatWallet, AskMrCreditCard, etc) that try to figure out what the best deal for cardholder rewards are.

“Third, interchange perverts underwriting standards, leading to less safe/sound financial institutions.”

Untrue. Interchange has nothing to do with underwriting standards. FICO and internal acquisition scoring have everything to do with it. Any population of acquisitions who you are banking on interchange driving the profitability of your business has north of a 720 FICO thus excellent credit risk. In order to sustain profitability, these accounts have to be making $1,000s of dollars in purchases EVERY month because they pay their bills on time and completely off each month. Anyone that is on the border of your underwriting standards, you’re hoping for revolving behavior because they will not be able to sustain the kind of spend seen in a transactor for very long therefore you’re trying to win on interest and fees without losses, interchange is an insignificant piece of the profitability equation for these accounts (~ 1/10 of interest and fees minus interchange). In other words, interchange is irrelevant in underwriting low scoring accounts.

“Fourth, no one knows whether or not prices have fallen. But that's not proof of regulation failing. Prices could simply have inflated at a slower rate. Again, an unknown, but not a knock on regulation.”

So we have real, concrete examples of how cardholders and potential cardholders have been impacted and no data that prices have fallen and yet somehow this is not a knock? If I reversed it said we have seen prices fall, but we have no data to determine if card holder rewards and fees increased what would be your answer here?

We have a known negative impact versus a nebulous and unquantifiable unknown that has not shown up in 7 years.

“Fifth, no one knows if merchant profitability went up or if that change related to interchange.”
Point taken.

“Ultimately it's irrelevant. How the surplus is split between merchants and consumers is a question of the competitiveness of particular consumer goods/services markets. But both merchants and consumers have a superior claim to the surplus than the card networks.”

I agree. Both merchants and consumers have a superior claim on the surplus. But in this case, consumers are now at a distinct disadvantage because one of their only weapons has been taken away in the form of their payment mechanism. When merchants are not competitive (why should I lower my price because my expenses went down when my competitor doesn’t, see my other post), what power does the consumer have on that claim. The entire claim goes back to the merchant.

“Sixth, MC/Visa/Amex haven't stopped doing business in Australia, nor have any Australian banks failed. They might or might not be less profitable (we don't know), but there's no right to profitability, regardless of antitrust laws.”

No one has pulled out of Australia because they changed their business model to deal with the regulatory regime, but consumers paid for it.

Just like there is no right to profitability for the merchant either. Why does the merchant have the right to a superior alternative to cash, but gets to pay nothing for it? However, unlike the merchant the networks and issuers have their price set for them while the merchant can still vary his or hers. No one forces a business to take plastic, they choose too. In fact, businesses can discount their purchases for cash according to network rules (no surcharges), but no one does. In all my travels, I know of only one business, Spec’s Liquor chain in Houston, TX that actually does this.

“Finally, the Charles River Associates study doesn't impress. It's funded by MasterCard. I've yet to see anyone not getting $$$ from the card industry give an out-and-out defense of the current interchange system. “

Who funded the study is irrelevant. You and I should be more interested in the methodology and conclusions. Poke holes in the work, don’t just dismiss the entire study because you do not like who funded it. Even in academia there is plenty of corporate and special interest sponsorship of research. Sponsorship should make us vigilant not dismissive.

“Beyond this, however, the Charles River Associates study only looks at rewards and annual fees; it doesn't look at interest rates, for example. There isn't great data on Australian card market interest rates, but it appears that rates on non-rewards cards are more competitive now.”

As I stated previously, non-rewards cards are directed at customers who are more likely to revolve. I think a more interesting question would be if I looked at the % of revolving balances and accounts in Australia today is it higher or lower then it was in 2003. Again, when there are no rewards to be had then you can only compete on APR. If you are a high value transactor (someone who is charging up and paying off every month), most likely you like the convenience of credit and even if the rewards go away you will still use your card. Of course then like everybody else you will be fixated on the APR even though you actually never pay interest.

Conclusions:
I go back to my original post.

1. Annual fees have increased
2. Rewards decreased
3. Merchant profitability went up (your point: which may or may not have anything to do with interchange not being passed to the consumer)
4. (Reworded) And no evidence to confirm nor deny that prices have fallen or increased at a slower rate

As you have said, no one has been able to document any possible benefit of this intervention in seven years. The RBA, the very organization that put this into place, has been unable to produce any evidence supporting their initial conclusions about how this was good for the consumer and Australia overall. I believe the preponderance of evidence at this point lies against intervention into interchange.

I've got too many exams to grade and a stiff fine for being late. There's a lot to say in response to hangtime79's posts, but not enough time. I will underscore a couple points, but am not conceding any of them.

First, who funds a study is critical to the integrity of the study. Have you ever seen an industry-funded study that has findings the industry doesn't like? I can't think of one. The whole business model of consulting shops like CRA is based on giving clients what they want. A consultancy that tells uncomfortable truths goes out of business. Every independent scholar who has approached the interchange question finds there to be problems (although there isn't always agreement on what). That might also be why every regulatory body that has examined interchange has moved to regulate it.

The argument that "everyone's doing it," hardly makes the practice better. Corporate and special interest sponsorship of research undermines the integrity of scholarship, if only in appearance. Witness the problems with pharmaceutical studies. No such conflicts for my work. Sponsorship should make us both vigilant AND dismissive.

Second, to clarify re: rewards. Cash back rewards, for example, aren't worthless, but consumers tend to overvalue them. Most cards restrict the total amount to something like $300/year. That's not much. If you charge over $15000, you've generated more interchange revenue than you're getting in rewards. But that cash is clearly income and should be taxable.

Third, you're just wrong on the underwriting issue. It's pretty simple. To the extent that an issuer makes an additional $100M in interchange revenue, that's another $100M it can afford to lose on the underwriting side and still come out even. Losing $100M isn't the same as risking $100M--given default probabilities, an issuer can place perhaps $1B or so at risk, and expect losses of $100M. Additional interchange revenue generates an expansion of credit several times larger. Also, I think you're confusing having a good FICO with not being a revolver. Lots of revolvers and/or sloppy payers have excellent FICOs.

Fourth, the burden of proof issue. I don't know why the burden of proof should be on those supporting regulation. I certainly do not accept it as a generic matter. Unless you believe, as a general matter, that cost-savings for merchants are not passed on to consumers (that's Wal-Mart's business model), I can't see why this assumption wouldn't apply to interchange. We don't have as much data as we would like from Australia, but frankly econometrics, even from the RBA, aren't up to this; there are just too many problems for conducting the incidence analysis. (I will point you to some work I did looking at gas station pricing in the 1980s, which indicates that there was a consumer pass-thru; query whether one can generalize from those examples--see my Harvard Journal on Legislation piece from 2007.) When I read your conclusions, though, all I see is that rewards cardholders have been forced to internalize the cost of their rewards. Boo-hoo. Defending free-riding shouldn't elicit much sympathy.

Finally, does it even matter if consumers benefit from interchange regulation? It certainly adds to the pro-regulation arguments stronger, but there is a strong case for interchange regulation, regardless of consumer benefits, but simply as a matter of payment system efficiency. The RBA was pretty clear that it was undertaking interchange reform for payment system reasons, not consumer welfare reasons. I think there's good reason to believe that interchange regulation produces consumer welfare gains, but let's keep in mind that from an antitrust law perspective, that isn't the issue. It's a question about benefits to competition, and there too, the pro-regulatory argument prevails.

To me it looks like the clear winner with this regulation are the big retail players - the walmarts of the world.... at the risk of oversimplification:

1. it is argued that using plastic leads to higher spend by cardholders...
2. that higher spend ($XX) leads to higher revenues (and profits) for merchants/retailers...
3. interchange in someways is the economic rent from retailers for using the plastic payment network AND it should include 2 key aspects: the pure cost of leveraging the network (A) + a giveback of the incremental profit coming out of incremental higher spend to other stakeholders (consumers +Card cos.)
4. card cos. DO share the earnings from interchange with customers in the form of rewards givebacks (do they do enough or not is an open question), not sure if the retail establishment needs to be compensated more...
5. The option of accepting cash at lower net prices to the customers always exists for retailers if they believe they are better off in an all cash economy - BUT we hardly see this happening except at small mom and pop stores
6. point 5 above also leads me to posit that BIG retailers perhaps are angling for the best of both worlds - consumers continue to use plastic as they are hence boosting spending at stores AND retailers reduce the cost they have to bear for participating in the value chain....


Not sure of the ancillary issues involved but perhaps 2 aspects could be considered in setting up any form of regulation:

1. should interchange slope even more by merchant size?
2. Should accepting cash at lower rates be made mandatory?
5.

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