Inside the Black Hole

WSJ’s Robin Sidel has a piece about the effect of the Durbin Amendment on the debit card interchange fees charged by credit unions and small banks. Or rather, the lack of a direct effect, as financial institutions with assets of less than $10 billion were unaffected by the regulation.

That is an interesting topic for a number of reasons and not least because when the exclusion of smaller financial institutions from the Durbin Amendment’s scope was first proposed, we heard quite a few uneasy voices from the under-$10 billion financial world. See, the small-bank concern was that, by allowing them to charge substantially higher debit card transaction fees than their bigger competitors, the Durbin Amendment would make them very unpopular with retailers and may prompt them to take retaliatory actions.

Now Sidel is reporting signs of a retailer backlash against this special treatment. But what actually prompted me to comment on her story was the fact that she has made some misleading statements about the structure of payment processing fees. This is important and is something many non-industry observers don’t seem to understand. Let me explain.

What Did the Durbin Amendment Do?

In order to understand what is wrong with the WSJ piece, you first need to understand what the Durbin Amendment did and what it didn’t do. So the Durbin Amendment mandated that the Federal Reserve ensure that debit card interchange fees are “reasonable and proportional.” The Fed responded by placing an upper limit of about $0.24 (0.05% + $0.21 + $0.01 per transaction), on average, on these fees, which is 45 percent lower than the pre-reform average of $0.44.

Now, what are interchange fees? These are the fees collected by issuers every time one of their cards is used for payment. These fees make up only a portion (which can and does vary greatly in relative size from one merchant to another) of the total amount paid by merchants for the processing of each card transaction.

The other portion of the card processing fees is charged by the payment processor, which is an entity that is separate from the card issuer and which has entered into an exclusive agreement with the merchant to enable it to accept bank cards for payment. The Durbin Amendment did not touch this part of the processing fees. Moreover, the processor-charged fees are the same for all debit cards, irrespective of whether they are issued by a large or a small bank. There are no reliable data on the average size of these fees, but what is known is that they can cover an enormous range and typically the very large merchants can squeeze them almost to the point of oblivion.

Who Collects Your Debit Card Fees?

Now that you know what the reform did and didn’t do, we can proceed to Sidel’s story. Here is the passage that caught my attention:

[S]mall banks and the middlemen that process their debit-card transactions will collect fees that are often three times the size of those imposed on cards issued by big banks. For example, a $100 sweater purchase made with a debit card would incur a fee of 95 cents on a card issued by a smaller bank, more than triple the 26 cents for debit cards issued by big banks.

Let’s break this down.

In the first sentence we are told that the total processing fees charged by a small bank can be “often three times the size of those” charged by a large bank. While it is true that small-bank debit interchange varies, while large-bank interchange no longer does, this is a misleading statement. You now know that, on average, the interchange fees charged by smaller banks will be less than twice as large as the ones charged by the bigger ones ($0.44 vs. $0.24). You also know that the processor’s fee is precisely the same for all debit cards, which additionally minimizes the difference.

But the second sentence is even more misleading. It is not that the example given by Sidel is necessarily unrealistic. On the contrary, it may, and probably is, a real-world one. In fact, we can find examples of even bigger discrepancies in favor of the small banks. But we can also give the following real-life example (using the $0.02 per-transaction processor fee that Sidel is using in her calculations):

A $3 latte purchase made with a debit card would incur a fee of 24 cents ($3 x 0.05% + $0.22) on a card issued by a big bank, almost triple the 9 cents (calculated using the 1.55% + $0.04 Visa CPS / Small Ticket, Debit interchange rate) for debit cards issued by small banks.

So we can also find substantial differences in favor of the large banks. Our calculations show that under the new pricing structure big issuers will be making more money from debit transactions in amounts of up to $11 or so than they were under the old one. This is why it is important to look at the averages when making such general statements.

The Takeaway

So the Durbin Amendment’s impact on processing fees is much more subtle than Sidel and many other commentators realize. And the biggest thing non-industry observers don’t seem to understand is that for a very large number of merchants the Durbin Amendment’s impact will be precisely non-existent. The reason is that the most prevalent pricing model out there – the tiered one – which comes in many different shapes and forms, does not pass any interchange savings (or dissavings, for that matter) on to the merchant. Instead, these differences, either positive or negative, are absorbed by the processor. But this is a topic for another post.

Image credit: WinonaDailyNews.com.

Learn how to lower your card acceptance cost

Learn how to accept credit and debit cards at the lowest processing costs. The Payment Card Acceptance kit contains a video and an e-book:

• Video – Card Acceptance Best Practices for Lowest Processing Costs (18 min).
• E-Book – Payment Card Acceptance Guide (19 pages).

Payment card industry rules prohibit merchants from charging consumers a fee for making a payment with a bank card. Compliance with this requirement ensures that both the cards and their users are not discriminated against at the checkout. However, there are loopholes, some of which are easier to define than others. For example, merchants can offer discounts to customers using other (non-card) payment methods (e.g. cash), which is straightforward enough.

But then we have an allowance made for a “convenience fee,” which is not nearly as clear-cut. It does constitute a clear surcharge to payments made with bank cards and yet, industry rules permit it. Why? Well, credit card companies and associations don’t have much of a choice. Let me explain.

What Is a Convenience Fee?

Industry rules state that merchants that offer an “alternate” payment channel (mail, telephone and e-commerce have been given as examples of such channels) are allowed to add a convenience fee to the transaction amount. If that definition sounds nebulous to you, that is because it is nebulous. Still, let’s see if we can decipher it.

If we are to make any sense of the convenience fee, we should begin by asking who, in practice, is charging it. Think about it for a moment. The most prominent examples are the federal and local governments (charging it for things like taxes and parking tickets) and huge utility companies (adding it to your gas or electricity bill, if you want to pay by credit card). In fact, I can’t really think of any other examples, although I’m sure there must be.

What does that tell us? I don’t think it would be a stretch to infer that the convenience fee has been more or less imposed on the Visas and MasterCards of the world. I mean, could they really have told the federal government that it was not allowed to add a convenience fee to a tax payment made by a credit card? After all, by law the Internal Revenue Service is required to collect the full amount of any tax owed, which precludes the deduction from it of a processing fee. Utilities, on the other hand, are monopolies, so they can (and many still do) opt to only accept non-card payment forms, if the card companies insist on collecting a piece of the payment amount. They own their customers who cannot go anywhere else.

Convenience Fee Rules

So faced with the inevitable, the card companies have chosen to make the best out of an unwinnable situation and have allowed convenience fees to be charged under certain circumstances. These rules state that convenience fees must be:

• Charged for a bona fide convenience in the form of an alternative payment channel outside of the merchant’s customary payment channels.
• Disclosed to the customer as a charge for using the alternative payment channel.
• Disclosed before the transaction is completed and the customer is given the opportunity to cancel it.
• Added only to a card-not-present transaction.
• A flat or fixed amount, regardless of the transaction amount. A percentage-based fee may only be charged for consumer tax payments.
• Included as a part of the total transaction amount.
• Applicable to all forms of payment accepted in the alternative payment channel.

Visa and MasterCard attempted to dissuade utilities from charging a convenience fee by introducing a special merchant category code (MCC) that offered preferential interchange rates (it’s funny that there isn’t a special MCC for the government). Only utilities that agreed to not charge convenience fees could qualify for this special treatment. I don’t know how many have signed up for the program, but anecdotal evidence suggests that it has not been hugely successful.

The Takeaway

If the distinction between a convenience fee and a surcharge that runs against the rules is still fuzzy to you, well, all I can say is that it seems to have been meant that way. The bottom line is that it would be close to impossible for ordinary businesses to legitimately charge such a fee. But more importantly, would you want to do it, even if you could? I can think of few things that could be more annoying to an e-commerce shopper than an unexpected fee that pops up at the last moment when she’s ready to check out. There must be a reason why only monopolies and the government would want to do it, right?

Image credit: R3views.com.

Learn how to lower your card acceptance cost

Learn how to accept credit and debit cards at the lowest processing costs. The Payment Card Acceptance kit contains a video and an e-book:

• Video – Card Acceptance Best Practices for Lowest Processing Costs (18 min).
• E-Book – Payment Card Acceptance Guide (19 pages).

It seems like almost every day someone will “discover” yet another unintended consequence of the limit that the Federal Reserve placed on debit card transaction fees, which took effect in October. The latest such discovery that I’ve come across is made by WSJ’s Robin Sidel who is writing about the “nasty side effect” the debit cap is having on retailers selling small-ticket goods.

The thing about all these side effects is that they were all both predictable and described in some detail on this blog and elsewhere before the limit was enforced. No one who was paying attention and had bothered to look into the numbers should be surprised. This whole situation is strikingly similar to, though not quite as potentially apocalyptic as, the euro crisis in that in both cases politicians and pundits were gleefully ignoring early warnings from experts only to later declare, when those experts were proved right, that everyone was surprised with the way events were unfolding. But let’s confine our attention for the moment to the side effects the WSJ piece is focusing on.

What the Durbin Amendment Did

The Durbin Amendment to the Dodd-Frank financial overhaul legislation charged the Federal Reserve with the task of ensuring that the fees issuers charge merchants accepting their debit cards – the interchange fees – were “reasonable and proportional.” The Fed responded by placing an upper limit of about $0.24 per debit transaction, which is 45 percent lower than the pre-Durbin average of $0.44.

The Fed’s decision ensured, among other things, that all debit transactions would be processed right at the limit. Now, though for most debit sales the cap meant a reduction in the cost of payment processing, for a significant proportion of the transactions it actually translated into a fee increase.

There are two reasons for that. The first one is that the way the Fed set its limit discriminates against merchants selling low-cost goods. The second is that Visa and MasterCard are no longer willing to give preferential treatment to merchants processing small-ticket transactions. To understand why, you will need to look at the numbers. Let’s do it.

Why Merchants Pay Higher Fees for Small-Ticket Transactions

Well, as it happens, we’ve already done that, which makes my job is a little easier. Before I do some copying and pasting, however, you will need to understand how the new debit interchange structure differs from the one it replaced.

Under the new rules, issuers can charge up to $0.21 per debit transaction plus 0.05% of the sale’s amount and an additional $0.01 can be tacked on for fraud prevention measures implemented by the bank. The per-transaction portion of the new interchange rate is substantially higher than the corresponding part of the old one. For example, the old interchange rate for small-ticket Visa debit transactions – the Visa CPS / Small Ticket, Debit – was 1.55% + $0.04. Here is how the two rate structures compare for transactions in amounts of $5, $10, $15, $20 and $25:

As you see, and as small-ticket merchants are now discovering, the old structure was much more beneficial for sellers of low-cost goods, with the difference growing exponentially with the lowering of the transaction amount. When you go into coffee shop territory – an owner of one is the protagonist of Sidel’s story – that difference can be as high as 100 percent (reached at a hair under $5) or greater. And if you think that such small-ticket transactions are exceptional, here is another piece of statistics for you. In 2009, U.S. merchants processed a total of 4.9 billion debit transactions in amounts lower than $5, according to Federal Reserve data.

The Takeaway

So we knew what the consequences of the new interchange structure would be on small-ticket transactions and warned about it, as did others. This is not difficult stuff, it only takes you a few minutes looking at the numbers to figure it out.

Yet, the amazing thing is that people just refuse to see the obvious. We keep being told in comments and emails that the banks should be made to accept the losses and move on without making much fuss. Now, whether that is the right thing to do in a free and open economy is an important question on which we may agree or disagree, but it is also an irrelevant one.

The point is that, whether anyone likes it or not, the issuers cannot and will not accept the losses and move on. Instead, they will look for and find ways to make up for lost interchange revenues. Someone will always be paying for this revenue-generating exercise. In this case, it is the small-ticket merchant. In most cases it will be the consumer. At the end, when it’s all said and done, the Durbin Amendment will have hugely benefited big-box retailers, the issuers will not be worse off than before the reform and consumers will end up footing most of the bill.

Image credit: Daily Trojan.

Learn how to lower your card acceptance cost

Learn how to accept credit and debit cards at the lowest processing costs. The Payment Card Acceptance kit contains a video and an e-book:

• Video – Card Acceptance Best Practices for Lowest Processing Costs (18 min).
• E-Book – Payment Card Acceptance Guide (19 pages).

The Financial Services Roundtable has published a fact sheet that lists the results of several studies into the impact on consumers of the Durbin Amendment that went into effect in the beginning of October.

While the FSR, a body representing 100 large financial services companies, clearly has a stake in the game, the numbers it is reporting are fairly uncontroversial and, unless you’ve been living under a rock in the past few months, you should have noticed that banks have been testing various strategies for making up for lost interchange revenues. While some of them have backfired and have been abandoned, most prominently the ill-conceived debit card fee tested by most large banks, other and less conspicuous fees have proved more resilient and are now here to stay.

Sen. Durbin and others may argue all they want that banks have no right to even try to recoup their interchange losses, but in reality they are trying just that and eventually will succeed in doing it. And it all started with the senator’s amendment.

How the Durbin Amendment Is Impacting Consumers

Here is what the FSR’s report says:

FACT: Most merchants will see substantial debit fee savings as a result of the Durbin Amendment. TSG Metrics Survey, October 14, 2011.

FACT: The average savings per merchant is $260.24 for every $100,000 of signature debit and credit card volume processed. Heartland Payment Systems Survey, October 28, 2011.

• Washington DC merchants received the highest average savings of $333.94.

FACT: There is no legal requirement for merchants to pass on savings from the Durbin Amendment to consumers.

FACT: In fact, 41% of merchants reported they do not intend to pass on lower debit card costs to consumers, when asked about the Durbin Amendment. DRF Survey, September 1, 2011.

• 56% of merchants in the survey reported they don’t know yet what they will do.

FACT: There is currently no published research showing that consumers have seen reduced fees at stores as a result of the Durbin Amendment.

FACT: Additionally, consumers are facing higher bank fees, according to the 2011 Bankrate Checking Survey. Bankrate Checking Survey, 2011.

• Just 45 percent of noninterest checking accounts are free of maintenance charges, down from 65 percent in 2010 and 76 percent in 2009.
• “The entire model of free checking has been turned upside down because of <Regulation E and the Durbin Amendment>,” said Ajay Nagarkatte, managing director of Chicago-based BAI Research, in the Bankrate survey.

There it is. It is clear (as it always has been to those who were paying attention) who is benefiting from the legislation and who isn’t.

How Banks Cope with the Durbin Amendment Effects

While the various debit card fees tested by Bank of America, Wells Fargo, Chase and other big banks have been getting the most attention, they are just one piece of the banks’ strategies for dealing with the Durbin Amendment’s revenue-slashing effects. These fees were eventually abandoned and the banks no doubt regret having ever decided to test them, but many other components of their strategies are very much alive.

Banking is still becoming more expensive, debit card fees or not. As the FSR study shows, free checking is quickly disappearing and other banking fees are creeping in, as the NYT recently reported.

At the same time banks are pushing hard to drive customers away from far less profitable debit cards and toward credit and prepaid cards, which were unaffected by the interchange reform. To that end, credit card offers are rapidly increasing in number, terms are improving and rewards programs are becoming ever more generous.

Prepaid cards were already the fastest-growing non-cash payment type in the U.S. even before the reform and now that bigger issuers are becoming more interested in them, their growth will accelerate further. American Express showed us what the future of prepaid will look like when it launched its fee-free card a few months ago.

The Takeaway

As we’ve been arguing on this blog all along, when it’s all said and done, the upshot of Sen. Durbin’s amendment will be that merchants will have increased their revenues, compared to the period before the reform took hold, banks will at worst be revenue-neutral and consumers’ cost of banking will have risen.

Yet, while on average consumers will be worse off, some will actually benefit from the better rewards programs and prepaid cards on offer. Unfortunately, the good rewards programs are only available to consumers with higher incomes and higher credit scores and prepaid cards are not yet, and are unlikely to ever be, nearly as widely used as needed to make a difference. So at the end those who will end up footing Sen. Durbin’s bill will be the ones who can least afford it.

Learn how to lower your card acceptance cost

Learn how to accept credit and debit cards at the lowest processing costs. The Payment Card Acceptance kit contains a video and an e-book:

• Video – Card Acceptance Best Practices for Lowest Processing Costs (18 min).
• E-Book – Payment Card Acceptance Guide (19 pages).

I didn’t see that one coming, although I guess I should have. Several retail groups have filed a lawsuit, claiming that the Federal Reserve has not complied with key requirements of the Durbin Amendment to the Dodd-Frank financial legislation that was passed in 2010.

Now, a lot has been written on this blog about the Durbin Amendment and regular readers know where we stand on the subject. We believe that the legislation amounts to a government-mandated redistribution of revenues ($7 billion or so annually) from one industry to another. Moreover, as we and others predicted when the amendment was first proposed, it has led to an increase in banking costs for consumers, as issuers ramped up fees to make up for lost interchange revenues.

So far, so straightforward, but now the clear winners of the interchange war are suing the Fed for not doing enough for them. I think that warrants a re-examination of the situation.

What Did the Durbin Amendment Do?

Famously, the Durbin Amendment charged the Fed with, among other things, ensuring that debit interchange fees – the fees issuers collect each time a merchant accepts one of their cards for payment – are “reasonable” and “proportional” to the banks’ processing costs. Though that mandate may seem to be somewhat lacking in clarity, there was never any doubt about how the Fed was expected to interpret it. The retail and bank lobbies did their best to help the Fed in its task and eventually Ben Bernanke’s outfit decided to place a limit on debit interchange fees that averages $0.24 per transaction, 45 percent lower than the pre-Durbin average of $0.44 per transaction.

At the time many of us thought that the Fed’s decision, while disliked by both sides, was a compromise they would each learn to live with. Well, the banks, for one, did move on and promptly began implementing strategies they had already devised for recouping their interchange losses. Some of these failed rather spectacularly, while others flew under the radar and yet others are still to come. However, the retailers, it now turns out, have never quite got over their displeasure and are now suing the Fed for placing the cap too high for their liking.

The Retailers’ Complaint

Initially the Fed proposed a debit interchange cap of $0.12 per transaction that was later lifted to its current level. It is likely, though we can’t be certain, that the retailers would have accepted the lower limit (and the extra billions of dollars in revenues that would have come with it), if it had stayed. By doubling it, however, the Fed had revealed whose interests it serves, their lobbyists now say. Here is Mallory Duncan, Senior Vice President of the National Retail Federation (NRF), one of the claimants in the suit:

The Federal Reserve was required by law to come up with swipe fees [interchange fees] that were ‘reasonable’ and ‘proportional’ but what we got were neither. Instead, the Fed allowed themselves to be influenced by the very banks they are supposed to regulate and raised the originally proposed cap to include expenses the law said were not allowed. In doing so, they literally gave away half the savings that could have been seen by merchants and their customers. We want them to go back and follow the law this time.

Never mind that Duncan repeats the completely unsubstantiated claim that retailers would pass the interchange windfall to their customers, here is the interesting part:

Rather than following the law, it’s almost as if the banks and the Fed were working hand-in-glove to block the genuine competition and common-sense price reductions Congress directed. The Fed’s regulations have blunted the competition that would have made greater savings possible.

In other words, by slashing their interchange revenues by 45 percent, the Fed had revealed itself as an accomplice to the evil banks in preventing the retailers from saving even more money for their customers. Right.

The Takeaway

I don’t quite know what to make of this story. It all seems so ludicrous to me that the only way I can make some kind of sense of it is to view it as the first salvo in the retailers’ campaign for a far bigger prize – a limit on the credit card interchange fees.

Now, considering that as a result of the debit interchange cap, our banking has become more expensive, while we are yet to see the promised reduction in retail prices, I would expect that our legislators would not repeat their mistake. But then, these side effects have always been so obvious that I didn’t expect them to make it in the first place.

Learn how to lower your card acceptance cost

Learn how to accept credit and debit cards at the lowest processing costs. The Payment Card Acceptance kit contains a video and an e-book:

• Video – Card Acceptance Best Practices for Lowest Processing Costs (18 min).
• E-Book – Payment Card Acceptance Guide (19 pages).