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Durbin’s Innovation Killer

Saturday, June 11, 2011

The Durbin amendment would raise costs for consumers, increase fraud, and kill innovation.

During the final debates on the massive Dodd-Frank financial regulation reform bill enacted by Congress last summer, Representative Jeb Hensarling (R-Texas) presciently observed that “there are probably three unintended consequences on every single page of this bill.” The unintended consequences of Dodd-Frank are perhaps best exemplified by the bill’s so-called “Durbin amendment,” a provision that places new regulations on both debit and credit cards, including punitive price controls on debit card interchange fees.

Attached as a floor amendment at the very last moment to the Senate version of the Dodd-Frank legislation, the Durbin amendment was passed with no hearings and minimal discussion of its likely impact on consumers and the economy. Since that time, however, many of the likely unintended consequences have been identified.

For example, the rate for interchange fees (the price a merchant pays when you use your debit card at your local retailer) has been set by the free market at about 44 cents per transaction. Under proposed Federal Reserve rules implementing the Durbin amendment, the controlled price would be 7-12 cents per transaction, a massive revenue cut. Banks covered by that provision (only those whose assets exceed $10 billion) have already announced that in response to this projected loss of tens of billions of dollars in debit card interchange revenues they will impose new or higher monthly service fees on bank customers. Among those most affected will be lower-income consumers who currently benefit from access to free checking accounts that will soon disappear. It is estimated that these new fees and other banking requirements (such as higher minimum balances) may drive as many as 1 million low-income consumers out of the mainstream banking system and into the hands of check-cashers, pawn shops, and other alternative financial providers.

The Durbin amendment was passed with no hearings and minimal discussion of its likely impact on consumers and the economy.

But while these obvious unintended consequences of the Durbin amendment are bad enough, especially for low-income consumers, a less-noticed but more far-reaching effect may be to destroy innovation in the payment card industry, harming consumers and the economy and promoting continued reliance on inferior substitutes such as checks.

For decades, payment cards have been much more innovative than other payment networks, such as checks and cash. Until recently, for example, checks were fundamentally the same basic payment technology as they were when they were first invented in the Middle Ages. In recent years, check processing has become somewhat more innovative, such as the adoption of the practice of converting paper checks into electronic images, but even this was brought about only as the result of heavy regulatory prompting. Checks are so obsolete as a payment mechanism that Great Britain has announced a plan to terminate all acceptance of checks by 2018 and to replace them with electronic transactions.

Astonishingly, one apparent goal of the Durbin amendment is to make payment cards relatively more expensive for a consumer to use in comparison to legacy paper-based systems such as cash and checks. Although printing companies and Brinks might favor this retrograde policy, it is difficult to understand why Senator Dick Durbin believes that government policy should encourage the greater reliance on 16th-century payment technologies in the 21st-century American economy.

If card issuers cannot recover the cost of new innovation, then they simply will not innovate.

And, indeed, the track record of innovation in the payment card industry is astonishing by any measure. Payment cards today provide an instantaneous, convenient, global, secure payment system acceptable 24 hours a day, anywhere in the world, in person or remotely (by phone or Internet). No other payment system in the history of the world has ever even begun to approximate the speed, security, and universal acceptance of today’s payment cards.

Moreover, the payment card networks have developed extraordinary processes to prevent fraud, tracking patterns of usage across the entire global network using complicated computer algorithms and cutting-edge technology while at the same time proactively monitoring suspicious charges at the level of each individual account in nearly real-time. Transaction speed at checkout has progressed rapidly, making payment cards much faster than checks and faster than cash for all but the smallest of transactions today.

The Durbin amendment, however, threatens this innovation. Two provisions of the amendment pose particular danger to innovation.

Merchants can be expected, whenever possible, to gravitate toward low-cost, high-fraud networks.

The first, mentioned already, is the new price control imposed on the interchange fees for debit cards issued by large financial institutions. The second is a provision that requires every payment card (including credit cards as well as debit cards) to be able to be processed on two different networks. So, for example, while today a debit card issued by ABC Bank might be processed by the MasterCard network and XYZ Bank might issue a Visa card, under the amendment, ABC Bank would have to offer two networks to process the transactions (say, MasterCard and Visa), thereby permitting the merchant to choose to process the transaction on the lower-price network. These two provisions could stifle innovation in the payment card industry.

Begin with the price controls on debit-card interchange fees issued by large banks (only debit cards, not credit cards are covered). First, as noted, one effect of these price controls will be to redistribute the costs of debit card operations from merchants who accept payment cards to consumers who use them. In turn, this will lead to higher banking fees for consumers, driving many consumers out of the banking system. While some of those consumers will make increased use of non-bank prepaid cards (which often sport very high fees), others will fall back on greater use of cash. Even for those not driven out of the banking system entirely, the Durbin amendment increases the cost and reduces the benefits of debit cards relative to other payment systems such as cash and checks, thus some of these consumers might reduce their use of debit cards too.

The arbitrary definition that the Durbin amendment provides for debit cards will promote regulatory arbitrage, as competitors seek to gerrymander products out of the amendment’s net.

This effect in itself could prove significant to the pace of innovation in the payment card system. The globally interconnected payment card system is a network that links together consumers, merchants, and financial institutions. Like any network, the value of the network itself increases as the number of users on all sides of the network increases and the marginal cost of serving the network falls. Thus, reducing the number of participants in the network—as the Durbin Amendment probably will—reduces the overall value of the network and the value for each member of the network. In turn, this will reduce the resource base available for capital investments in innovation.

Second, and more directly, the Durbin amendment’s price controls on debit cards by definition will reduce the incentive to make any investments that cannot be recouped in the regulated price permitted by the Federal Reserve. Thus, while the Durbin amendment purportedly permits the recovery of “reasonable and proportional” costs tied to the card issuers’ actual cost, in fact it permits the recovery of only the “incremental cost” of transactions, thereby excluding costs of operation, such as advertising, issuing cards, and providing customer support.

To the extent that card issuers make improvements in card quality, such as increased processing speed or security, it is highly uncertain whether those costs could be recouped as allowable costs under the terms of the Durbin amendment. If so, then this would provide a major deterrent from investing in those card attributes as opposed to simply attempting to minimize the cost of card operations.

New banking requirements may drive as many as 1 million low-income consumers out of the mainstream banking system and into the hands of check-cashers, pawn shops, and other alternative financial providers.

This predictable effect, of course, is consistent with the lessons learned from decades of public utility regulation. From Ma Bell to locally regulated cable and electricity utilities, history teaches that industries subjected to regulation, especially price controls, stagnate technologically. If card issuers cannot recover the cost of new innovation, then they simply will not innovate.

Consider the fate of ISIS, a joint venture formed by three U.S. wireless companies—AT&T Mobility, T-Mobile, and Verizon Wireless. The purpose of the venture was to create and operate a new, nationwide mobile payment and commerce system based on a mobile wallet concept and operationalized through Near Field Communication systems in retailers. Moreover, this new technology could provide unbanked consumers with electronic bill pay and other banking services—a group that is expected to grow in size as a result of the Durbin amendment. In a comment letter filed with the Federal Reserve in February, ISIS noted that the combination of the Durbin amendment’s price caps on debit transactions and the requirement that every payment system provide an alternative choice would starve them of the revenue needed to start up the business against established competitors.

Banks have already announced that in response to this projected loss of tens of billions of dollars in debit card interchange revenues they will impose new or higher monthly service fees on bank customers.

Ironically, ISIS’s business plan was to grow by charging merchants lower prices than the prevailing rates in the market. The political intervention of the Durbin amendment arbitrarily reduced interchange fees for incumbents, thereby eliminating ISIS’s opportunity to enter as a low-cost provider of payment services. Given the substantial up-front investment that merchants would have needed to make to equip their stores for smartphone payments, this lower interchange fee was seen as an enticement to make those investments. Post-Durbin, however, merchants no longer have an incentive to invest in smartphone payments because debit fees have been knocked down so low and it will be difficult for ISIS to make the case for the merchant to invest in the new payment system. As a result of the Durbin amendment, ISIS is no longer going to offer a new payment system to rival MasterCard and Visa and will instead piggyback on those existing networks—thereby reinforcing the purported lack of competition that supposedly animated the Durbin amendment in the first place.

This stifling effect on innovation is heightened by the targeted applicability of the Durbin amendment to only the largest financial institutions. But because large institutions are the driving innovators, the Durbin amendment essentially taxes innovation in the one sector of the banking industry where innovation is most likely to occur. Small financial institutions are in general not the innovative leaders of the banking system.

On the other end of the scale, the expansive definition of “debit card” under the Durbin amendment has been interpreted by the Federal Reserve to include any card or similar product that directly debits a consumer’s account. The definition thus would include PayPal, for example, or mobile phone payment or remote payment systems that directly debit a consumer’s account. Unless these payment systems are exempted by some other provision of the Durbin amendment, the stringent price controls would be imposed to them as well. Note that this means, for example, that the cost of building out a new mobile payment system (such as the ability to swipe a cell phone for payment) or remote payment via mobile phone would be an expense for which the price control provisions of the Durbin amendment would not make allowance. At the very least, the arbitrary definition that the Durbin amendment provides for debit cards will promote regulatory arbitrage, as competitors seek to design their products not solely to maximize their economic and technological viability but to gerrymander them out of the Durbin amendment’s net.

Astonishingly, one apparent goal of the Durbin amendment is to make payment cards relatively more expensive for a consumer to use in comparison to legacy paper-based systems such as cash and checks.

A second area in which price controls will likely stifle innovation is in fraud control. The Durbin amendment provides that the Federal Reserve “may” allow for an adjustment for the permitted fees for costs incurred by the issuer in preventing fraud. In the proposed rule-making issued by the Federal Reserve in December, however, the Federal Reserve made no allowance at that time for fraud prevention costs. Moreover, even if the Federal Reserve does decide to permit recovery of costs related to fraud prevention, there remains the vexing question of what costs will be classified as recoverable under the law.

There are a range of actions or non-actions that issuers can take to reduce the potential for fraud to occur. For example, the issuer can invest in very high levels of data security or lesser levels of security. Will the Durbin amendment permit recovery for those who make higher investments in greater data security? Or will those investments simply be lost?

Consider a more direct problem involving recovery for fraud prevention costs. In Europe, most payment cards use the “chip and PIN” system of security, which replaces the magnetic stripe on the card (which simply contains information that can be copied and used without the physical card) with an embedded microchip (which cannot). Although certainly not foolproof, the chip and PIN system has reduced fraud where it has been introduced and is generally thought to be more secure than the simpler magnetic stripe system used in the United States. On the other hand, the incidence of fraud in the United States is substantially lower than elsewhere—hence it has not been thought economically justifiable to adopt the chip and PIN system in the United States. According to one estimate, for example, it costs about $2 to issue a traditional magnetic stripe card and $15 to $20 to issue a chip and PIN card. If card issuers are unable to recover the costs of adopting a chip and PIN card-based system from interchange fees, then consumers will have to bear these transition costs directly, which seems likely to slow their adoption. In turn, this will slow the willingness of merchants to invest in the special payment terminals needed to enable payment by chip and PIN technologies.

History teaches that industries subjected to regulation, especially price controls, stagnate technologically.

Exacerbating the effects of the price control provisions of the Durbin amendment is its requirement that every payment card (including credit, prepaid, and government benefit cards) be required to offer at least two networks for each transaction, thereby permitting the merchant to select the least expensive. This inevitably will produce a race to the bottom in terms of creating incentives to innovate. Innovation and product improvement requires ongoing investment. Even if those investments were permitted to be recovered under the Durbin amendment as a legal matter, it is unlikely that an issuer could recover them as a practical matter because those cards that refused to make those investments would be able to offer their product at a lower rate than those that did not. Moreover, merchants generally do not bear the costs associated with fraud and other quality issues, thus they have no incentive to choose a more secure but higher-cost network. Because merchants can externalize the costs of fraud onto consumers and issuers, they will have little incentive to use a network that benefits consumers through greater security but costs more. Instead, merchants can be expected, whenever possible, to gravitate toward low-cost, high-fraud networks. Moreover, because this requirement of offering a choice of networks applies to all types of payment cards, the overall effect with be felt across all types of cards.

Passed with no hearings or debate, many politicians have felt buyer’s remorse as the scale of unintended consequences wrought by the Durbin amendment have started to become more appreciated. On Wednesday, the Senate rejected a law by Democratic Senator Jon Tester of Montana—hardly an emissary of Wall Street—that would have delayed the implementation of the Durbin amendment from its effective date of July 21 for further study of the proposal. Although the proposal garnered 54 votes in support—a strong indication of growing disaffection with the proposal—it fell 6 votes shy of the 60 votes needed to break a filibuster. Had it passed the Senate, Representative Barney Frank of Massachusetts (a critic of the Durbin amendment himself) predicted that it would have had the votes to pass the House as well. As a result, it may be that the last opportunity to forestall this disastrous legislation has collapsed for the time being.

The United States has long been a leader in innovation in payment systems—MasterCard and Visa, for example, are the dominant payment processing networks in the world. New technologies such as PayPal and mobile payment technologies are poised to revolutionize the payment landscape still further, bringing with it new opportunities and security threats to consumers and the economy. The Durbin amendment threatens this global leadership and innovation. Congress should reconsider this ill-advised venture into government price-setting before it is too late.

Todd Zywicki is Foundation Professor of Law at George Mason University School of Law and co-editor of Supreme Court Economic Review.

FURTHER READING: Related articles include “Washington’s Seizure of Sunk Capital” by James V. DeLong, “End It, Don’t Mend It” by Peter J. Wallison, “More Equity, Less Government: Rethinking Bank Regulation” by Mark J. Perry and Robert Dell, and “Can Our Last International Advantage Withstand the Dodd-Frank Act?” by Alex J. Pollock.

Image by Darren Wamboldt/Bergman Group.

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