THE IMPACT OF THE FED S PROPOSAL TO CAP DEBIT CARD INTERCHANGE FEES ON CONSUMERS AND SMALL BUSINESSES

Transcription

1 1 THE IMPACT OF THE FED S PROPOSAL TO CAP DEBIT CARD INTERCHANGE FEES ON CONSUMERS AND SMALL BUSINESSES March 29, 2011 Richard Schmalensee Professor of Economics & Management, MIT Sloan School

2 2 Quick Summary

3 What s the issue? 3 Banks and credit unions give their checking account customers a debit card they can use at ATMs and to buy things. Banks and credit unions received $15.7 billion in 2009 in fees from merchants when their customers used these cards to pay. The Fed s proposed price controls on debit fees would reduce what banks and credit unions earn from merchants by 73% - 84% and reduce what merchants pay to banks and credit unions by a similar amount does it matter to anyone else?

4 Impact on consumers depends on how banks & credit unions respond v. how merchants respond 4 This might look like a wash for consumers: Banks and credit unions lose debit interchange fee revenue that used to support their checking account businesses; Merchants save on transaction processing costs. If banks raised fees & merchants cut prices and both pass on the same percent of revenue & costs, it would be largely be a wash. The Fed staff stopped there, concluded that overall it s hard to anticipate what the overall [e]ffect on consumers will be. But it s not really hard: economic logic plus readily available facts show that consumers will be harmed.

5 Will show that predictable differences in responses will lead to consumer harm 5 Retailers will respond slowly to interchange fee reductions that save a dime on a $60 purchase; large retailers may not fully pass them through. Banks & credit unions will respond quickly to fee reductions that cut checking account revenue 20%; will likely pass them through fully. Asked how much Durbin will affect Home Depot s earnings during an investor call, CFO Carol Tome responded we think the benefit to The Home Depot could be $35 million a year. -- February 23, 2011 J.P. Morgan Chase, TD Bank, and PNC have already changed their ATM policies to collect more fees with more ATM fee rises expected in the coming months. Banks scrambling to replace billions of dollars in revenue expected to be lost from new federal regulations on overdraft charges and debit cards. --Wall Street Journal, 3/16/2011

6 What s the impact on small businesses? 6 Most small businesses have checking accounts and use debit cards to pay for things. They will pay higher fees to banks & credit unions just like consumers. But only a fraction of small businesses accept debit cards for payment (only 10% of small businesses are in retail). Even those that do may lose because their merchant acquirers (the firms that pay interchange to banks) may not pass on their savings quickly or fully. Therefore, most small businesses will also be harmed by the proposed regulation of debit card fees.

7 7 Background on Debit Cards & Pass-Through

8 Debit cards are part of the bundle of checking account services provided by banks & credit unions 8 Debit cards enable people to pay with funds they already have in their checking account. Banks & credit unions usually give people ATM/debit cards when they sign up for a checking account, and people can only get one of these cards with a checking (or other asset) account. Banks & credit unions make profit from checking accounts overall but provide a mix of fee-based and free services. Debit interchange fees are one of the major sources of revenue from checking accounts (about 20%); reducing debit interchange makes checking accounts less profitable, all else equal.

9 Interchange fees in four-party networks 9 Networks set the interchange fees that merchants pay and issuers receive but don t keep any of the fees for themselves. Merchant acquirers send debit card transactions from merchants to the networks and reimburse merchants for what customers pay, less a merchant discount. Acquirers pay interchange fees to the bank that issued the debit card, so merchant discounts are above the interchange fee. Acquirers contracts with large and small merchants differ. Large merchants have interchange-fee plus contracts Small merchants have blended-fee contacts.

10 Fed price controls would cut debit interchange fees by $33-$38 billion in first 24 months the period on which we focus 10 Average interchange fee was 44 cents on a $38.58 transaction (1.14%) Some basic debit interchange facts (2009): $15.7 billion of total interchange revenue (excludes prepaid cards) Federal Reserve submitted two proposals for comments 7 cent safe harbor: up to an 84% reduction 12 cent cap: = 73% reduction Focus on first 24 months since Fed might revise after 2 years and hard to forecast much farther $38 billion in fees lost in the first 24 months under 7 cent safe harbor $33 billion in fees lost in the first 24 months under 12 cent cap Projections based on historical debit transaction growth, includes <$10 billion exempt institutions, most analysts think it unlikely they will get more than cap

11 Basic economic principles for evaluating the impact of changes 11 Firms in highly competitive industries will eventually pass all of an increase or decrease in cost through to consumers in the form of higher prices or lower prices. Firms in industries that are not highly competitive do not necessarily pass on cost changes fully to consumers; empirical evidence suggests they typically pass on about 40-70%. Firms do not pass on small changes in costs quickly because it is expensive and inconvenient to change prices. Prices tend to stay constant for many months at a time.

12 12 What Would Happen to Checking Account and Debit Card Fees?

13 Why banks and credit unions would likely pass on debit-card Fee losses quickly and almost fully to consumers 13 The proposed drastic cuts in debit card interchange would cut bank and credit union demand deposit revenues substantially Banking is highly competitive Banks and credit unions have reacted quickly to other major revenue reductions Banks and credit unions are preparing similar reactions now to these price controls

14 This would be a big financial hit to checking accounts (estimates for 2009) 14 $56 - $64 revenue loss per consumer checking account Impact $79 - $92 revenue loss per small business checking account 21% - 24% reduction in checking account revenues 7% - 9% reduction in retail banking revenues Response These are massive reductions that banks and credit unions can t ignore and can t absorb. They have no choice but to raise fees or lower costs through less service.

15 The retail banking industry is highly competitive 15 Fed and DOJ have found retail banking markets coincident with metropolitan areas. Use HHI to measure degree of concentration and find concentration is generally low, with 21 of 25 largest metro areas being well below level for which mergers are a concern. 83 different banks and credit unions in the D.C. metro area (13 in Georgetown alone!). [D]eregulation of products and markets intensified competition among banks and between banks and nonbank financial companies Competition will continue to be intense, and few banks, if any, will be insulated from its effects. - George Hanc, FDIC, The Future of Banking in America 2004

16 Rapid debit card growth and increased banks debit interchange fee revenue subsidized other banking products 16 Rapid debit card growth increased banks debit interchange fee revenue, which was passed through to consumers via expanded free checking and other fee reductions.

17 As banks received growing interchange fee income in the 2000s, many additional services were also added 17 Expansion of ATMs and Branches Online Banking Online Bill Payment US ATMs have grown from 227k in 1999 to 425k in ,000+ bank branches in 2010 In 2000 most consumers did not have access to online banking, and if they did they had to pay extra for it Now virtually all banks provide free online banking 76% of household will be banking online by 2011 (Forrester Research) In 2000 many banks charged customers for online bill payment By 2004 approximately two-thirds of the largest banks provided online bill payment as a free service By the end of the decade free online bill payment was ubiquitous Mobile Banking Introduced in 2007 Free to customers Serves 12 million customers projected to reach 45 million in 2014

18 Free checking nosedived in 2010 as a result of Regulation E changes in July & worries about interchange caps 18 About 20 million accounts lost free checking in 2010; trend is accelerating.

19 Banks increased fees and cut services quickly in response to Regulation E changes in July Date Bank Post Regulation E Checking Account Feature Changes July 2010 July 2010 September 2010 November 2010 Bank of America Wells Fargo Citibank JPMorgan Chase No more free checking for basic accounts $8.95/mo for teller access and paper statements Waived if customers make direct deposits or maintain an avg balance of $1,500 Eliminated free checking for new customers - $5 / mo on its basic account Waived if customers make a direct deposit of $250+ or keep an avg balance of $1,500 Announced an $8/mo service fee Waived if customers perform a combination of direct deposits, debit card purchases, bill payments, auto deductions, ACH payments, checks paid, cash withdrawals at ATMs Will stop issuing debit cards with rewards by Feb 2011 and existing reward cards will be phased out December 2010 JPMorgan Chase Basic account has a $6/mo fee Waived if customers make a direct deposit of $500+ or 5+ debit card purchases

20 Community banks are already considering changes in response to interchange fee caps 20 73% are considering imposing annual or monthly debit card fees 93% would be required to charge customers for services currently offered for free 61% would consider imposing monthly fees for all checking account customers 50% would consider imposing a per transaction charge for debit cards 44% would consider eliminating debit rewards programs 20% would have to eliminate jobs or halt plans to open new bank branches.

21 Why are small community banks, exempt from Durbin, planning to react? 21 Because of competitive pressures from large, regulated issuers and merchants incentives and ability to discriminate against high-fee cards via acceptance and routing, community banks do not believe they will get higher fees The Fed staff seem to think this is a reasonable belief: The networks may simply decide it is simply too costly or too complicated to maintain two separate interchange fee schedules. If the networks do decide to establish two separate interchange fee schedules it s possible that merchants would discriminate against [exempt] issuers by declining to accept their cards --Robin Praeger, Federal Reserve economist at December 16, 2010 Board meeting

22 Large banks have made or are planning to raise fees/slash service 22 Wall Street Journal (3/16/2011): Some financial institutions recently introduced new charges on checking accounts as a way to make up some of the revenue that will be choked by rules imposed by the Dodd-Frank financialoverhaul law. If you re a restaurant and you can t charge for soda, you re going to charge more for the burger. Over time, it will all be re-priced into the business. --J.P. Morgan CEO Jamie Dimon: Wall Street Journal (1/5/2011): As regulation curtailing financial institutions from levying certain charges on consumers has mounted over the past year, banks have had to dream up new fees to replace those now trimmed by laws

23 Consumers would lose a significant portion of $33-38 billion in the first two years 23 Banks would quickly pass most of the $33-38 billion in reduced fees through to consumers in the form of increased fees and/or the elimination of valuable services. There would be an accelerating roll-back of free checking and other benefits added during last decade. Can expect restrictions on debit card features that lead to high fraud and other costs, such as limitations or fees for buying high-cost items or for card-not present transactions.

24 Lower-income individuals would be particularly hard hit 24 Expansion of free checking in 2000s pulled millions of unbanked into the banking system and gave them access to payment cards. In 1995, 45% of low income households ( 50% of median) had access to a payment card. Mainly because of debit cards, 67% had access in Rollback of free checking will push some lower-income households back out of the banking system and prevent others from getting into it.

25 25 What Would Happen to Merchants Prices?

26 Theory and evidence shows that merchants won t pass on debit cost reductions quickly or fully 26 Debit fee reductions are a tiny portion of merchant costs less than 2 cents of savings for a $10 item. Merchants don t pass on small cost changes quickly because prices are sticky (because of menu costs ). Many merchant categories are not intensely competitive so 100% pass through is unlikely even in the long run. Small merchants may not even get much savings to pass through. Their merchant acquirers probably won t lower their blended payment fees quickly or by amount of debit savings.

27 Large merchants won t pass through their savings quickly or fully 27 Large merchants have interchange fee plus contracts penny for penny reductions from merchant acquirers if fees cut But extensive economic literature on price stickiness shows that tiny reductions in cost (less than 0.2%) won t trigger price cuts. Long-run pass through likely to be limited by market power in some merchant industries and locations. DOJ/FTC find relatively concentrated local markets for supermarkets, office superstores, movie theatres to take a few example. Estimating long-run pass through of savings would require detailed analysis, but economic studies find 40-70% typical pass through in typical industries.

28 Large merchants will enjoy a windfall 28 Large merchant windfall estimate: Keep 90% in first year = $10.6 $12.3 billion Keep 50% in second year = $6.6 $7.7 billion Total two-year windfall = $17.2 $19.9 billion Asked how much Durbin will affect Home Depot s earning, CFO Carol Tome responded we think the benefit to The Home Depot could be $35 million a year. - February 23, 2011

29 Small merchants may not see much savings from fee reductions 29 Merchant acquirers charge small merchants a blended rate, fixed for the life of the contract, across all payment types; no automatic pass-through. Merchant acquirers unlikely to pass much savings on quickly and probably won t pass on all savings fully even in long run. Not as much competition for small business accounts, high switching costs for small businesses who may not easily be able to get a new merchant account Analysts following merchant acquirers expect they will get a windfall from Durbin as a result i.e. they will get at least some of the benefits of fee reductions, not the small merchants.

30 Small businesses will not benefit 30 Durbin and others claimed that this legislation would help small businesses. But proposed price controls won t do so. 15 million small businesses have checking accounts. Their fees are going to go up probably about $79 - $92 per account. Only a few million small businesses accept payment cards (only 10% are retail) and we saw that those that take cards may not get much money back anyway. So 15 million small businesses get hit with higher checking account fees. A minority of those businesses would get some reductions in their debit card fees.

31 31 Who Wins, Who Loses

32 Durbin was sold as a boon to consumers and small businesses, but the Fed s proposal would hurt them 32 Consumers would lose because checking account fees would rise a lot more than prices they pay to merchants would fall. Lower income households would lose more because checking accounts would be out of reach for many who would also lose debit cards, key to ecommerce and many other things. Small businesses would lose because checking account fees would rise. Most small businesses don t take debit cards, and those that do wouldn t see much near-term cost reduction. But there is a bright side: large merchants would enjoy a twoyear windfall of almost $20 billion.

33 Contact information and further reading 33 Richard Schmalensee: Professor of Economics & Management, MIT Sloan School Further Reading: The full text of our consumer impact submission to the Federal Reserve can be downloaded at: Also, a summary of the net impact of the proposed fee reductions on consumers and small businesses is in the March 2011Lydian Journal: assets/lydian_journal/lydianjournal-march.pdf

34 34 Additional Slides

35 Interchange fees by network and transaction type 35

36 Low Income Households 36