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The Solomonic Test of Swipe Fee Reform: Reverse Political Economy

posted by Adam Levitin

King Solomon's judgment regarding the two women claiming to be the mother of the same child is a familiar story--the King proposed chopping the baby in two and giving each mother half of the child. One mother consents, while the other says that she will forfeit the child. The one who prefers receiving 0 child to .5 child is then awarded the whole baby because the real mother would never consent to the child being harmed.  A market test of value. 

We can apply similar logic to the question of debit swipe fee or interchange reform.  A major question in swipe fee reform is the degree to which merchants' savings from reduced swipe fees will be passed through to consumers. If the savings would be pocketed by merchants, it would just be a redistribution from banks to merchants. That's the right result under antitrust law, but it doesn't make as compelling of a policy argument as protecting consumer surplus.  

So what does this have to do with King Solomon?  It means we should give the baby (swipe fee reform) to the party that values it least because that's the party that will pocket the smallest part of the consumer surplus.  

My sense is that the banks are vastly outspending the merchants on lobbying.  The merchants don't seem to have put in a lot of money.  They ran a cartoon strip in some Capitol Hill papers a couple of years back, but they certainly aren't putting in nearly as much money as the financial services industry. There are entire metro cars in DC plastered with (really ineffective) posters opposing swipe fee reform, and even anti-reform TV commercials (YouTube link anyone?).  

Banks are spending more money than merchants on the lobbying because they think that they'll keep more money if there is no reform than the merchants would make if there is reform. The reason the merchants don't think they'll make much money from reform--because they anticipate the savings flowing through to consumers.  So applying Solomonic wisdom, we should give swipe fee reform to the merchants because they value it less than the banks.  Going full speed ahead with swipe fee reform is the best route for consumers. 


Adam, its even simpler then that.

One is full upside (merchant), while the other is complete downside (issuer). Who is going to fight harder? Another way, who fight's harder the invader or the person who lives there?

In fact, we are starting to see the case of consumers being impacted with the first round of Durbin. Chase making noise about limiting debit transactions to $100. Just about every rewards program that I am aware of related to debit is either been shuttered or in the process of doing so with possible fees coming next. These actions do not sound particularly consumer friendly.

Merchants if they want credit card interchange reform are going to have to meet half way. I will be so bold as to say Durbin for the credit and charge card business will never happen without some significant concessions from merchants. What does that mean? That means

A. merchants will be paying a blended rate of interchange based on transaction expense and % of sales. If it is not done this way it creates too many issues when it comes to small versus large transactions. If you are straight transaction expense you get where we are going today on debit side (limits on transaction size). Make it fully % sales based and you limit the profitability of smaller transactions and upset merchants with large ticket sizes.

B. Merchants are going to have to give up fraud protection either substantially or completely. When someone passes a merchant a fake $20 or $50 bill, the merchant eats that cost. The federal government and the bank don't reimburse the business for a fake $20. The same is going to have to happen in the credit world to get any traction. This will be table stakes for the next fight.

This could be implemented in a number of different directions. It could be straight interchange expense. It could be the forced upgrade to the the latest and greatest POS systems. It could be something like in Europe where the most risky transaction volume and equipment pays a disproportionate amount of the fraud expense billed as interchange. Remember, just because fraud wasn't conducted at your place of business doesn't mean it didn't originate there.

The key to all this if merchants want to pay rock bottom prices for a valuable service then they are going to have lose some of their protection or they can begin extending credit on their own (feel free to look into the economics of small-ticket credit card programs, they are quite ugly now after CARD Act implementation).

My own thoughts:
Yes, transaction processing is a valuable service.

No, customers shouldn't be the only one paying for it because they are not the ones who derive all the value.

Yes, merchants who accept credit cards have significantly higher revenue and that value-added service should be allowed to price what the market will bear.

Yes, merchants have a choice. They can choose to accept only cash (I know plenty who do) and not pay the %, but ultimately will limit their revenue potential and ticket size. Or merchants can pay the interchange and try and make it in back in incremental sales through transactions and $ ticket size. The option as always is with the merchant.

Hangtime79, years ago, checking accounts carried fees associated with the cost of maintaining them, and rewards programs on debit cards didn't exist. But go back and track the development of debit card rates over the last 7 years and see how the institution of debit rewards prgrams tracks in parallel the rate development for merchants - well you get the picture of what's going on.

So to eliminate rewards programs for debit cards - since when should merchants have to pay for what is essentially a bank marketing expense?? So I think to suggest elimination of debit card rewards as being consumer unfriendly is really not anymore unfriendly to the consumer than the debit rates that are passed through to the consumer in merchant retail pricing. The effects of the astronomical debit rate increases that have been passed on over the last 7 to 10 years are just not seen.

And I don't think Chase will cut off transactions at $100 - cardholders might leave and Mr. Dimon isn't that stupid. Greedy, yes, but not stupid.

Your comments are mainly about credit and are based on a rational assessment of reality. But credit is an argument for another day. Durbin is about debit, which is very different than credit.

They are different vehicles for payments with significantly different risk profiles, so any discussion about debit interchange should not be mixed with comments about credit.

The comments to this entry are closed.


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