Sen. Richard Durbin (D-Ill.) earlier this month introduced legislation that aims to manufacture competition in the routing of credit-card transactions. If enacted, the measure would require that merchants be able to choose from at least two networks when processing most credit-card transactions.
While this would result in competition over routing, it would harm other forms of competition—notably in the variety of credit cards available and the range of benefits provided to cardholders. It would also very likely impede fraud detection and prevention. As such, it would almost certainly do more harm than good.
Co-sponsored by Sens. Peter Welch (D-Vt.), J.D. Vance (R-Ohio), and Roger Marshall (R-Kan.), the Credit Card Competition Act would require all card-issuing banks with more than $100 billion in assets to include at least two networks on their cards, one of which must be a smaller competitor (i.e., not one of the two largest networks). Most credit cards in the United Statesare issued by these larger banks and, indeed, the change would affect the vast majority of currently issued cards.
Transactions made using a card branded by a particular network, such as Visa or Mastercard, are typically required to be routed over that brand’s network. The Mastercard and Visa networks currently route about 75% of all U.S. credit-card transactions, while American Express and Discover account for most of the remaining 25%. Some merchants have claimed that these restrictive requirements impede “competition” and thereby raise the cost of transactions, which they say are then passed on to consumers.
In practice, however, the restrictions are a feature of the system, not a bug. Requiring transactions to be routed over the network branded on the card ensures that the security and fraud-prevention protocols established by the network—and agreed to by the card issuer—are followed. It also enables the network to set interchange fees—that is, the fees paid to issuing banks—at levels that maximize the network’s value to all participants, especially cardholders and merchants.
The latter point is worth exploring in more detail because it is essential to have a proper understanding of the economics of credit cards and, hence, of the problems inherent in Durbin’s proposed bill. Credit cards are a classic example of what economists refer to as “two-sided markets”: cardholders and card issuers on one side, merchants and their acquiring banks on the other, with the card networks acting as platforms that intermediate the two sides.
In most two-sided markets, one side of the market typically subsidizes the other. Newspapers, for example, allow advertisers to communicate with readers. Advertisers are willing to subsidize the production of the paper (and/or website)—including the costs of journalists, commentators, editors, and so on—to increase its appeal to certain demographics in the target market.
In the case of payment networks, merchants as whole are willing to subsidize card transactions so that issuers can offer rewards, insurance, and other benefits to cardholders, thereby increasing the number of cardholders and the amounts they spend on cards, which in turn benefits merchants through increased spending, reduced counterparty risk, and reduced transaction times relative to cash payments. These subsidies are made via interchange fees.
Over many decades, card networks have identified a range of interchange fees that balance the two sides of the market. Among other things, this has enabled issuers to provide a wide variety of cards to consumers, including cards co-branded with airlines, hotels, and retailers that incentivize loyalty and increase spending with those brands. Networks have also developed interchange-fee rates that better suit merchants with low-ticket sales.
While merchants as a whole benefit from the use of cards, larger merchants have complained for years about high interchange fees. Legislators and regulators in many jurisdictions have responded to these complaints by introducing price controls and other interventions. The results have been predictable: in every jurisdiction that has capped interchange fees, card issuers have responded with reduced benefits (such as rewards) and/or increased cardholder-related fees.
Durbin famously introduced an amendment to the Dodd-Frank Act in 2010 that led to the imposition of caps on debit-card interchange fees for banks with assets of more than $10 billion. A recent study by Vladimir Mukharlyamov of Georgetown University and Natasha Sarin of the University of Pennsylvania found that this reduced annual revenues at covered banks by about $5.5 billion. Seeking to recoup some of the lost revenue, banks on average doubled their monthly fees on checking accounts; increased the minimum deposit required for “free” checking by 21%; and reduced the availability of accounts with no-minimum free checking by about half.
This was a diametric reversal of the trend in the decade prior to passage of the Durbin amendment, during which banks used debit-interchange fees to subsidize free checking. Just as those subsidies enabled many more low-income consumers to have a bank account, their removal almost certainly led many people to exit the banking system.
At the same time, consumers received little (if anything) in the way of benefits from the Durbin Amendment. A 2014 survey of merchants by the Federal Reserve Bank of Richmond found that 98% of respondents either did not lower prices following Durbin, or actually increased them. Mukharlyamov & Sarin also found that merchants passed through relatively little of the savings they made. Even in the highly competitive market for gasoline, they estimated that consumers saved less than one cent per gallon of gas. The result: many poorer consumers ended up paying much higher bank fees but received little in return.
But the Durbin amendment’s effects were not limited to large banks. The measure also required all issuers, large and small, to include more than one unaffiliated payment network on their cards. This had the effect of dramatically reducing interchange fees for PIN-debit transactions, because the operators of unaffiliated PIN networks were not bound by the default interchange fees set by agreement between the issuing bank and the main national payment-card networks (Visa and Mastercard).
Following the introduction of mandatory “competitive routing” on debit cards, smaller PIN-debit networks saw a profit opportunity. But those networks were not focused on maximizing the value of the system, so they were willing to carry payment messages at a lower interchange rate than the major networks. Smaller issuing banks were forced to accept these lower PIN-debit interchange fees, and the major networks were forced to cut their PIN-debit fees to remain competitive. As a result, many smaller banks have experienced reductions in interchange revenue similar to their larger cousins and have responded similarly—by reducing the availability of free checking accounts.
Ironically, middle-class consumers with good credit scores have been able to avoid the worst consequences of the Durbin amendment by increasing the average amount held in their checking accounts, thereby maintaining access to free checking, and by using credit cards instead of debit cards, thereby maintaining access to rewards. But Durbin is now coming for them too.
the Credit Card Competition Act would result in merchants routing transactions across payment networks that offer lower interchange fees. The larger networks will be forced to respond by lowering their interchange fees, as well, resulting in significantly reduced issuer revenue. Issuers will respond by reducing or eliminating card benefits, such as reward programs. Co-branded cards—of which there are currently more than 200 million in the United States—will almost certainly disappear, as the rewards on such cards are largely funded by interchange fees. In addition, card issuers will likely increase annual fees on cards and make fee-free cards available only to individuals with very high credit scores.
To be clear: the Durbin bill, which claims that it will increase competition, will unambiguously harm competition in the supply of credit cards, reducing the choices available to consumers. Moreover, far from benefiting merchants, the bill will almost certainly harm merchants overall by reducing spending. Small merchants selling low-ticket items are likely to be most adversely affected, as they will see little if any reduction in fees and yet will almost certainly experience a decline in business. Reduced rewards and higher annual card fees might also drive consumers to switch to less-secure payment methods, such as cash.
To the extent that lower-cost networks attract a significant proportion of traffic, there could also be consequences for the security of card payments. First, the effectiveness of payment networks’ systems for monitoring fraud is dependent on training their machine-learning programs with as much data about users’ spending habits as possible. If the flow of that data is curtailed, the system’s effectiveness will be harmed. Second, some security features—such as the ability to place a temporary stop on a card’s transactions when that card has gone missing—may not function properly if the data is not routed over the main card network.
Ironically, Durbin himself recognized at least some of these facts back in 2010, which is why such requirements were excluded from the original Durbin amendment. As he noted at the time:
About half of the transactions that take place now using plastic are with credit cards, and there is a fee charged—usually 1 or 2 percent of the actual amount that is charged to the credit card. It is understandable because the credit card company is creating this means of payment. It is also running the risk of default and collection, where someone does not pay off their credit card. So, the fee is understandable because there is risk associated with it.
It seems unlikely that Durbin intended to harm poorer consumers with his amendment to the Dodd-Frank Act, but we now know that it did. It is odd, then, that he should be supporting new regulations that would impose similar routing requirements on credit-card companies, rather than calling for the repeal of his mistaken old law. The new bill would magnify the effects of the original Durbin amendment, leading to increased security risks; higher costs for consumers; reduced spending; and adverse effects for small-ticket merchants.