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The Fed Bails Out the Banks...Again

posted by Adam Levitin

[Updated 6.30.11]

If anyone doubted who set the marching tune for the Federal Reserve Board, it was sure clear today. The Fed announced its final rule under the Durbin Interchange Amendment, and it was quite the handout to the big banks.  

The Durbin Amendment instructed the Fed to pass rules that clarified its instruction that debit interchange fees must be reasonable and proportional to the incremental cost of authorizing, clearing, and settling an individual debit card transaction.  The Fed came out with a proposed rule last December that solicited comments on two alternative safe harbors.  One was for a flat fee of 7 cents per transaction, the other for 12 cents per transaction. The Fed also solicited comments on whether debit cards should have to be routable on 2 unaffiliated networks or on 2 unaffiliated PIN and 2 unaffiliated signature debit networks (4 networks total). 

Well, today the Fed came out with the final rule, and what a surprise.  

Instead of picking between the 7 or 12 cent safeharbors, the Fed now has adopted a 21 cent plus 5 basis points on transaction volume safe harbor.  So the Fed tripled the safeharbor!  This is nicely described by the Fed as "a variant of the [12 cent safeharbor] approach".  Is the variation to reverse the digits? That seems more like something out of the Goldberg Variations (see here for a discussion of retrograde inversion) than a rational approach to regulation.  

What makes the 21 cents plus 5bp safeharbor even more outrageous is that there are already debit card interchange rates that are lower than that! Grocery and quick serve restaurants often have flat fee debit interchange rates of 19 cents.  If debit networks can do the transaction already for 19 cents, shouldn't that be the maximium possible safeharbor? And what about the Fed's findings that the median cost was 11 cents and the 80th percentile was 19 cents? 

If you want to understand the f.u. attitude from the Fed, take a look at footnote 105 in the final rule. It states that:

Several merchant commenters referenced a 2004 industry study (STAR CHEK Direct Product Overview study; First Annapolis Consulting) that found the per-transaction costs to be 0.33 cents for PIN debit and 1.36 cents for signature debit, but the study was not provided with the comments.

And the mighty Fed couldn't be bothered to go find the damn study? It's not hard to call up STAR or First Annapolis--I'm sure they'd provide it gratis to the Fed. 

[Updated:  To this we might ask what new information the Fed had that caused it to change from 7/12 cents to 21 cents.  As far as I can tell, the Fed did not have any new data. Instead, it was simply persuaded that the costs that it was permitted to include in the calculation included not just the actual cost of authorizing, clearing, and settling the transaction but costs that it believed were not clearly addressed by the Durbin Amendment. I think the plain language of the Durbin Amendment is pretty clear as to what costs can or cannot be included, but if there were any doubt, the legislative history of the Amendment makes things crystal clear. Maybe this gets challenged in court, but even if it is successfully challenged, every year of delay is another $4B in the pockets of issuers.] 

Then there's the ad valorem component of 5 bps. The Fed explains it as:

The ad valorem amount is 5 basis points of the transaction’s value, which corresponds to the average per-transaction fraud losses of the median issuer.

There are three four problems with this.  First, there is absolutely nothing in the statute that permits the Fed to include fraud losses as part of the "reasonable and proportional" calculation. Instead, the Fed is only permitted to include "the incremental cost incurred by an issuer for the role of the issuer in the authorization, clearance, or settlement of a particular electronic debit transaction." The fraud loss is not part of the cost incremental or otherwise of ACS. It is a completely separate type of cost. This was the Federal Reserve just disregarding the statutory langugage to hand the banks a bone. 

Second, the inclusion of an ad valorem fee was basically an ambush of merchants and consumer groups.  The Fed noted laconically that "Most merchants objected to an ad valorem component," but there was never a major push from merchant or consumers groups on this issue because it seemed to be out of contemplation given the proposed rulemaking. I know I would have had a lot more to say in my comments to the Fed had I thought they were thinking of any ad valorem component.

Third, there is absolutely no difference in the cost of authorizing, clearing, and settling a debit transaction that is $20 versus $200 versus $2000.

[Updated:  Fourth, the Fed applied a patently inconsistent and indefensible methodology to achieve the 5bp number.  The 5bp number is the average fraud loss of the median issuer. (I'm not totally sure what that means--the median issuer's average fraud loss or did they average the fraud losses and take the median?).  The 21 cents, however is based on the 80th percentile of banks that responded to a voluntary Fed survey.  Let's put aside the data quality issues of a voluntary survey in which respondents with low costs clearly understood that it was in their interest no to respond.  What is the rationale for the Fed taking an average cost in one part and an 80th percentile cost for the other?  I'm not sure there is one, much less one that stands up to Chevron deference. That's just bad statistics.] 

I've had my misgivings about the reasonable and proportional part of the Durbin Amendment, but I think the routing exclusivity provision was a major step forward in creating a more competitive debit card market.  The Fed, however, decided that more competition isn't good for the banks and went with the routing exclusivity option that requires less, rather than more competition for debit card routing. 

There's a broader lesson about financial regulation here. The passage of the Durbin Amendment and then the defeat of the Tester-Corker bill to delay the Durbin Amendment's effective date showed that financial reform could take place over the objection of the big banks if there were a strong non-bank lobby involved (here, retailers). But that political balance only holds true in Congress. Once the regulatory implementation was handed over to the Fed, the banks were playing with a home court advantage.

The lesson here is that if we want serious regulation of banks, we can't trust it to be done by bank regulators. We've seen the Fed and the OCC time and time again bend over backwards to let the banks out of statutory requirements. We've seen this with inaction (HOEPA regs), with aggressive preemption (and OCC is back to its old tricks...).

And this isn't just in the realm of consumer finance. This is also in the safety and soundness area. I'm not talking about stretched interpretations of section 13(3) of the Federal Reserve Act. I'm talking about affiliate transaction rules and Prompt Corrective Action, cornerstones of the safety-and-soundness regime. Saule Omarova has a great paper that shows how the Fed granted affiliate transaction waivers like a drunken sailor during the financial crisis.  Those were rules that went back to 1932-33 as part of Glass-Steagal.  

And remember Prompt Corrective Action? That was a response to all of the Federal Home Loan Bank Board's screw ups during the S&L crisis (Who you say? There's a reason the FHLBB doesn't exist any more...). PCA is clear of a bunch of tripwires as you can get. The whole point was to make sure that the bank regulators regulated, not coddled. But Bernanke announced that he was suspending PCA for the banks during the financial crisis. Only after the stress tests cleared the big banks did PCA get applied to the small banks, and with a vengance. What a sorry state of the world we live in where the bank regulators are the last people we can trust to actually regulate the banks. 


The only difference between the Goldberg Variations and the "variation" at issue here is that the Goldberg Variations were a work of timeless genius and a spiritual uplift to all of humanity. Otherwise, same exact thing.

Well this should just about do the only small businesses surviving in! Unless the small businesses can pass the debit fees onto the clients this will make them paying out twice the amount in debt fees than they do for their yearly taxes on their business income. This is a devistating blow to small business and big business. Everyone needs to go to a cash basis and not pay these fees out to these criminals.

Criminals? Don't banks in this example have a right to charge whatever price they want for a service they provide (as long as it's clearly disclosed, of course)? Don't buyers of this service (small businesses, retailers, etc...) have the option of not buying this service and therefore not accepting debit cards? Finally, given fees are roughly similar for all businesses aren't they simply passed through to consumers such that no one business is at a disproportionate disadvantage over another from a pricing standpoint?

I dunno, Adam. I watched the Fed briefing the other day, and the aftermath seems to be pretty muted. Perhaps one could attribute this to EVERYONE being cowed by the banks, but I think that the alternative reading is that the line that the Durbin Amndmt wanted the Fed to draw just isn't clear. Now, there are certainly some parties who think that the line is clear, like Wal-Mart or other retailers. Or people like you who rage against the clear injustice that occurs when the Fed caves to the bankers, regardless of the circumstances surrounding that capitulation. But even Durbin's response was pretty muted, which suggests that he wasn't too sure if he wanted this to head where it could have headed.

Ultimately, the Fed basically split the baby in half. Very Solomonic. Again, certain interested parties would see that outcome as an affront (as befits the response to a Solomonic outcome) while others, like you, would view the process as an affront. We could argue about whether that particular split is justified by the Durbin Amendment. For example, should the new costs that the Fed has added qualify under the statute? The one that I'm aware of that would clearly seem to qualify would be network processing fees, as leaving those out might placate one's sense of fairness, but would seem to be something that banks pay to perform transactions. Not sure what the others are, but it's likely that they fall in a similar gray area related to performing transactions.

More generally, is a Solomonic response a reasonable outcome to a messy situation? Is it justified by the statute? I dunno. This was a death match between two well-funded, well-organized interest groups, and if the Fed managed to find a reasonable middle ground, that might not be a terrible outcome.

Chabot, the process was rotten and so was the result. The statute didn't tell the Fed "split the baby." It said do X and the Fed did Y. If you look at the legislative history, such as Senator Durbin's floor statement, there wasn't any doubt what the legislation meant. Bernanke found a seemingly plausible grey area to play in within the statutory language, but that doesn't mean that it holds up with real scrutiny. The fact that the Fed changed so dramatically from the proposed to the final rule is a strong indication that it wasn't doing what it was supposed to do. A Solomonic response isn't a reasonable outcome to legislation that directs a judgment for one party.

It makes no sense to include network processing fees in permissible interchange because those are generally paid by the acquirer separately, not by the issuer, and get folded into the merchant discount fee. Including them in interchange double counts.

Just as a factual matter, and I might be wrong about this (although a quick google search indicates that I'm not), I believe that networks charge fees to both banks when processing a transaction. I can't see how this would be an interchange fee in that it's paid by both banks to the network for each transaction. And, in fact, it serves as a cost of each transaction to the cardholder's bank. So I don't see how including that fee/cost would be double counting. If a cardholder's bank pays a fee to a network for each transaction, why would that not be a relevant cost for the cardholder's bank under the Durbin Amndt, regardless of whether the merchant's bank pays an analogous fee? You may object to including it as a matter of fairness, but as your response astutely notes, the Durbin Amndt doesn't say anything about fairness.

If that's the type of example that will be worked over, then I'm not sure that the Durbin Amndt really did give instructions to the Fed that would satisfy you in terms of generating the outcome that you obviously want.

Thanks for the info! I was gathering as much resources over the net and i happen to come across your page. I see that you've posted the latest news about interchange fees that's apparently been experiencing by credit consumers and retailers (Myself included) As tempting as cards rewards may be on your daily splurge, so is your credit balance. I love to shop and spend as much as i can using my credit card and when i read the news about it i felt overwhelmed!

Apparently, Credit card rebates and interchange fees force retailers to charge consumers more for anything on the menu. This is store markup, and it expenses us a lot. To make things better, as reported by the LA Times, stores should present two sets of costs on everything, cash compared to card. The LA Times says that even people who pay cash only are not immune, and follows up with a modest proposal: All stores should present cash price compared to credit/debit price. In the long run, the main difference is staggering.

Article Source: All consumers shoulder cost of credit card rebates

The results can be overwhelming because both consumers and retailers alike doesn't seem to agree with the propositions on the benefits of this rebate and i feel for their madness about this disappointing issue.

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