The Basic Law and Economics of The Durbin Amendment

After a couple of posts on the Durbin Amendment, it has become clear that not everyone has read and familiarized themselves with the Durbin Amendment.  So if I may, allow me to lay out a few basic principles:

1.  The Durbin Amendment Imposes Price Controls, Not Transparency: This is the key misunderstanding–by its terms, the Durbin Amendment requires the Federal Reserve to set the allowable price of interchange fees at the incremental costs of processing debit transactions.  So it expressly prohibits recovery for the fixed costs of running a debit program (operating branches, customer service, etc.) and prohibits a normal return on investments in running the debit card program.  In that sense it turns debit cards into something more like checks, where the effective interchange fee is set a zero and the banks and consumers have to bear the costs of checks (so, for example, you are issued your debit card for free but you have to pay to buy your own checks).  The argument also ignores the obvious threshold point that payments are Coasian by nature, so costs are reciprocal, so the whole concept of “making costs transparent” by arbitrarily reallocating costs when the costs arise reciprocally is simply a logical error.

2.  We Already Have Transparency For Payment Cards: Current law already permits merchants to discount for cash and merchants are permitted to steer consumers to alternative payment methods if they like.  So if it is just about transparency, we already have that.

3.  We Don’t Require Transparency for Anything Else: Right now many merchants offer “free parking,” which requires those who take public transportation or walk to a store to subsidize those who drive.  Presumably merchants offer free parking because it increases their overall profitability (the same reason they take payment cards, of course).  To justify the Durbin Amendment on the ground of transparency would be analogous to argue that the government should not only require the disclosure of how much free parking costs, but to actually prohibit stores from offering free parking.  We also don’t require merchants to disclose the full costs of paying with cash (safes, employee theft, employee time spent handling and counting cash, armored cars, etc.)–costs that payment card payers have to subsidize for cash payers.

4.  Payment Cards are Two-Sided Markets: They are like newspapers, where the advertisers subsidize the readers.  In fact, like debit cards, many newspapers are entirely advertising supported and are given away for free (magazines are sold at subscription rates much below their costs).  If, for example, the government imposed price controls on what The Onion could charge display advertisers, what would happen?  First, they might consider charging readers instead of giving it away for free.  Second, they would try to shift advertisers to unregulated margins, such as classified advertising or online.  Third, they might reduce their services to reduce costs, such as reducing their distribution.  There is nothing anomalous about offering a product for free if the cost is recovered somewhere else in the system.  And while it is possible that consumers as a group might be better off if the government prohibited free parking or imposed price controls on newspaper advertising rates, it certainly isn’t obvious and would require actual economic analysis.  Transparency in and of itself would have virtually nothing to do with the question of whether the pre-price controls price structure was more efficient that the post-price controls structure.  To the question of how it could be profitable to offer free debit cards pre-Durbin, this is the explanation–think of how it is economic to produce a free newspaper (free to readers but not advertisers).

5.  The Antitrust Rationale for the Durbin Amendment is Completely Wrong: I discussed this in a Washington Times column some time ago.  Because payment cards are a two-sided market, in competitive equilibrium, saying interchange fees for merchants are “too high” is identical to saying that fees to consumers are “too low.”  In Canada, for example, where interchange fees on debit cards are zero, consumers pay high costs for debit cards–higher than the new $5 Bank of America fees.

The problem, if there is one, is not a lack of competition, but rather that much of the competition is for consumers, not just for merchants.  Payment card networks seek to balance these two sides of the market through the prices that they charge to consumers and merchants in order to maximize the overall value of the network.  As a theoretical matter this can result in prices being too low for consumers and too high for merchants.  As a theoretical matter it can also result in prices being just right for both or too high for consumers and too low for merchants.  It all depends on the assumptions and elasticities of the players in the system.  So the theoretical argument is interesting, but to date, undetermined as an a priori matter.  As an empirical matter the question is equally unsettled.  What we do know, though, is that there are network externalities from payment cards and there are positive social externalities from bringing people into the mainstream banking system and reducing reliance on cash (which facilitates crime and tax evasion, for example).  If theoretical or empirical studies eventually do establish that market competition leads to market failure, then we’ve got a different question.  But based on current theory and empirics there simply is no such consensus.

In fact, this was the decision regulators made in Australia.  There it was determined that consumer prices for payment cards were too low and that as a result consumers inefficiently overused payment cards.  So interchange fee price controls were specifically intended to reduce merchant costs and raise consumer costs with the goal of reducing card use and increasing use of paper payments.  And by general consensus prices did go up for consumers–annual fees went up on credit cards for example and rewards were reduced–and costs for merchants went down.  But there is no evidence of any measurable cost savings being passed on to consumers yet in the form of lower prices or higher quality and there has not been even an effort to try to establish whether any purported retail price reductions to consumers were larger than the increased banking prices.  It is also not clear that use of payment cards actually declined even though consumers now pay more and get less from using them.  Overall, the Australian central bank seems to believe that that the overall market response–higher bank fees, lower merchant costs, and an assumption of retail pass-through despite the lack of evidence or estimate of size–was a good thing.  I think that the overall mix of intended and unintended consequences was a bad thing for efficiency and appears to largely have resulted in a wealth transfer from consumers to merchants (driven largely by all of the relevant elasticities of the players in the various interrelated markets).  This result of being largely a wealth transfer rather than an efficiency effect is seen as one likely outcome in markets where use and acceptance of payment cards is already high.  This doesn’t even consider the negative social effects of swelling the ranks of the unbanked.

But, unlike the justifications that are offered for the Durbin Amendment, at least the Australian case was theoretically coherent.  By which I mean that they acknowledged the unintended consequences identified by theory and practice and decided to do it anyway.  I disagree.  But if there is an argument for interchange price controls it is the one adopted by the Australians, not the ones that have been offered for the Durbin Amendment.

6.  Even If There is a Market Failure, It Doesn’t Justify The Below-Cost Pricing of the Durbin Amendment: But note that even if one adopts the Australian argument that costs are too low to consumers and too high to merchants, it still doesn’t support the precise price control of Durbin, which excludes fixed costs and a normal return.  If one is convinced that there is a market failure (and as I indicated, I’m not persuaded of that), it still doesn’t justify requiring below-cost pricing.  It would at least permit full-cost pricing (like traditional utility rate regulation).