wipe card, enter PIN, and money floats off into the digital ether. This routine is performed tens of millions of times daily as American consumers proffer plastic debit cards to buy everything from lattes to lawnmowers. This process usually seems far removed from politics, but the structure of debit card systems and, more importantly, who pays the transactional costs associated with them, is a critical question of political economy that has pitted banks and retailers against each other since banks began issuing debit cards in the 1970s.
We got a rare glimpse of that conflict on July 31, when U.S. District Court Judge Richard Leon ruled that the Federal Reserve had disregarded Congress’s expressed intent in assigning the Fed rulemaking authority over debit card fees as part of the Dodd-Frank financial institution reform law. According to Leon, instead of following the wishes of Congress, the Fed was guilty of “inappropriately inflating all debit-card transaction fees by billions of dollars and failing to provide merchants with multiple unaffiliated networks for each debit-card transaction.” It’s quite a loaded accusation, but what happened exactly?
In compliance with the law, the Fed initially planned to set the “swipe fee”, which merchants pay every time a consumer uses a debit card, at somewhere between 7 and 12 cents. The banking lobby weighed in, however, and before long the rate was set at 21 cents, plus .05 percent of the purchase price to cover bankcard fraud losses. This was lower than the average fee before the financial crisis sired Dodd-Frank (44 cents) but the reasons advanced for moving the fee to roughly double what was originally proposed were dubious at best.
So a coalition of retailing associations sued the Fed in November 2011, maintaining that the 21-cent cap is an “unreasonable interpretation” that exceeds the authority given to the Fed by the 2010 law. It also asserted that the Fed wrongly interpreted a provision of the law that requires that merchants have a choice of which bank network handles their transactions. Judge Leon agreed that the Fed deviated from the law’s intent by factoring certain bank expenses into the cap, such as losses from fraud, that went beyond the scope of the law.
The ruling is a victory for retailers, who pay the fees directly, and for consumers, who pay them indirectly through higher retail prices, whether they use plastic or not. It is, in turn, a loss for banks, which had lobbied the Fed to keep the interchange fees high, translating into billions of dollars of revenue in the banks’ coffers. Not surprisingly, the banks are not taking this ruling lying down. After the court issued its judgment, the New York Times vividly illustrated the conflict with this August 1 report:
The banks say the retailers have pushed for the lower fees not to benefit customers, but to pad their own bottom lines. “It was—and still is—all about trying to help retailers increase profit margins while providing no real benefit to consumers”, said Frank Keating, president of the American Bankers Association.
To hear a bank lobbyist accuse retailers of wanting to pad their bottom lines comes across as top-shelf chutzpah. It’s certainly unclear how keeping fees high benefits consumers.
The banks have urged the Fed to appeal. Even if there is no appeal, the 21-cent fee will remain until new rules can be written, which, given the banking lobbyists’ clout and the Fed’s natural interests, seems likely to run into entirely predictable “unforeseen delays.” After all, similar lobbying at the Securities and Exchange Commission has meant that Dodd-Frank’s CEO salary disclosure rule remains unwritten after nearly three years.
To understand what should come next, we must look back at the history of this whole business. A clear lesson emerges about when government ought to provide a public good, and when competition actually destroys value rather than creates it.
o start, let’s ask a question: Why did Congress place this regulatory authority over bankcard transaction fees with the Fed in the first place, given that the Federal Reserve System is in turn owned by the banks it regulates? Why not choose another, less self-interested bank regulator, such as the Comptroller of the Currency or the FDIC, or agencies more amenable to retailer or consumer interests like the Federal Trade Commission or the newly created Consumer Financial Protection Bureau?
The answer is that, unlike these other agencies, the Federal Reserve has been in the payment systems business for a very long time. The Federal Reserve’s glamorous public role in recent years has been that of lender of last resort and, through its quantitative easing program, the state spending engine of last resort as well. Yet, out of the spotlight, the Fed also manages a nationwide check-clearing system and has done so since shortly after the creation of the Federal Reserve System in 1913. The entire history of credit and debit card regulation, and the older system of check clearing that preceded it, suggests that the Fed was the proper institution for this regulatory task. This history also suggests, however, that Congress’s mandate did not go far enough: The Federal Reserve could have best served the interests of the financial system by eliminating debit interchange fees entirely, just as it did with check discounting in the early 20th century.
Before the Fed came into existence, check clearing and settlement, the process by which checks moved from a merchant to the merchant’s bank to the consumer’s bank and funds moved in the opposite direction, operated through private clearinghouses and interbank relationships. Checks were often cleared at a discount, which can be thought of as kind of like interest in reverse: Discounts are fees charged upfront as a percentage of the value of a check to compensate the bank for the time it takes for funds to return and for the risk associated with the transaction, especially for checks traveling long distances.
The Fed’s check-clearing system operated as a “public option” that competed with the private clearinghouses and correspondent banking networks that had moved checks around the country since the 19th century. In operating its system, the Fed was especially keen to end the practice of discounting checks, so that checks would clear at their face value, or at par, with the cost of maintaining this payments system borne by the Federal Reserve Banks. Thanks to the Fed’s size and reach, par clearance became standard for all check transactions, whether facilitated through the Fed or the private systems.
This was a huge boon, particularly to consumers and merchants. When a consumer bought groceries and wrote a $10 check to a grocer, the grocer was assured that he would receive all $10 when he deposited the check in his bank. The transaction costs associated with accepting checks disappeared, and with them, in this sense, went the payment system itself. As Fed architect Carter Glass predicted, par clearance tore down the “toll gates upon the highway of commerce”, promoting the use of checks and helping further knit together a financial system divided along state, regional and political lines.
Still, while the clearing and settlement of checks was now free, merchants still bore the risk that a check might be returned if the consumer had insufficient funds in his or her account. Par clearance offered no insurance against bounced checks, which is why some merchants would not accept checks from customers with whom they were not familiar—and some would not accept checks at all. This was the central problem that debit cards were meant to solve, and it is the primary reason that banks and the payment systems companies Visa and MasterCard expect merchants to pay for the privilege of accepting debit cards. Unlike checks, debit card transactions are guaranteed, whether the consumer has the funds or not.
This guarantee has long been the central value proposition of bank-issued payment cards—first charge cards, then credit cards, and finally debit cards. With each evolution the fees paid by merchants have declined, but they have yet to disappear. The costs associated with maintaining the payment system remain a bone of contention among banks and merchants.
It is perhaps ironic, then, that banks developed the first payment cards to help small merchants address a power imbalance with their larger counterparts. These payment networks, introduced in the 1940s and 1950s, were built to shift the credit-granting activities of small merchants to their local banks, and with them the risks associated with extending short-term credit privileges to consumers. By centralizing credit and billing systems within the local bank, small merchants could more easily compete with large retailers like Sears and A&P that offered credit through their own card programs.
Early on, banks did not intend for these cards to be vehicles for consumer lending; instead, the first bank-issued payment cards were charge cards where consumers were expected to repay their balances every month. If they did not do so, consumers would quickly find their payment privileges suspended. To recoup the costs associated with offering this service, banks returned to the old practice of discounting, charging the merchant as much as 7 percent of the value of goods sold through charge-card plans. This charge is now called the merchant discount, the interchange fee or the swipe fee. (Anyone who carries an American Express card should recognize this model, which the company still uses for its green, gold, platinum and black charge cards. Like the older bank programs, Amex charges a steep discount. This explains why many merchants don’t take American Express and, in turn, why many qualified consumers don’t want one.)
Banks justified this charge because merchants received payment for the goods instantly, instead of having to wait and collect the balance from the consumer. Cards also eliminated the risks associated with handling large amounts of cash. Eventually, banks began to experiment with what we now know as credit cards, where consumers could keep a revolving balance and pay interest charges, allowing banks to collect from both merchants and consumers simultaneously. Over time, banks, and later the payment systems companies, lowered merchant discounts, claiming more and more profits from interest charges and fees paid by consumers.
Initially, too, bankcard networks only involved three parties: the consumer, the merchant and the issuing bank. For example, Bank of America began signing up merchants and consumers for its BankAmericard in 1958. When a consumer used a BankAmericard at a participating merchant, the merchant would submit the sales draft to Bank of America and receive instant payment, minus the discount. Bank of America would then bill the consumer, completing the cycle entirely within the bank. The system was also bound by state borders, since at that time banks could not build branches across state lines.
The system became more complex when multiple banks joined together to issue cards within the same system. In 1966, Bank of America started licensing the BankAmericard to other banks around the country, creating a national network that allowed consumers to use BankAmericards issued by their local banks at merchants in different states, and soon around the world. Under this system, a typical transaction worked as follows: Once a consumer used a BankAmericard to make a purchase, the merchant would forward the sales draft to its bank for immediate payment. The merchant’s bank then paid the merchant for the goods the customer purchased, less the discount, and sent the sales draft to the consumer’s bank. Next, the consumer’s bank repaid the merchant’s bank and billed the consumer for the goods purchased.
This process, now aided by massive computer systems, was originally conducted by phone and mail, and it often took more than a month to translate the purchase into a final bill. It was also chaotic: As charge volume increased, the early national bankcard systems almost collapsed under the weight of millions of paper receipts. In the early 1970s, BankAmericard issuers tried to pass these interchange functions to the Federal Reserve, which was clearing sixty million checks a day and seemed capable of handling card transactions as well. Though the Fed had the expertise to facilitate a national payment card system, technological incompatibility and Fed reluctance scuttled the plan. The Fed was not eager to handle these new consumer debt instruments, especially those involving a discount.
Consequently, the two major interchange systems, Visa (formerly National BankAmericard, Inc.) and MasterCard (formerly the Interbank Card Association) developed as private corporations owned by the banks that were members of each system. This structure created conflicting priorities for these organizations. Initially, banks signed up merchants and issued cards to consumers, while the interchanges facilitated the transactions, set the merchant discount rates, and promoted the systems as a whole. But there seemed to be no reason why the interchanges couldn’t recruit merchants as well, as Visa eventually did with JC Penney, and no reason why they couldn’t offer financial services directly to consumers.
Still, while the interchange systems wanted consumers and merchants to realize value from their card networks, banks were ultimately both their owners and customers, and so wanted the systems to coordinate their credit card profits not compete for merchant or consumer customers. The payment system companies, then, while distinct from the banks, have been most concerned with protecting bank profits, facilitating a system of cooperative competition where banks compete with each other while working together through the exchanges.
As these national interchange systems grew in fits and starts through the 1960s and 1970s, they attracted increasing scrutiny from Congress and Federal regulatory agencies. Regulators worried that credit cards threatened bank stability, contributed to inflation by promoting spending and rising consumer prices, invited fraud and theft, and, as a cooperative system, raised the specter of antitrust.
Through the 1960s, Congress considered a variety of measures, including barring banks’ participation in credit card markets entirely, but as cooler heads prevailed members looked for the Federal Reserve to step in and exercise regulatory authority over the emerging industry. Bank regulators, such as the Comptroller of the Currency or the FDIC, tended to focus more on bank safety and solvency than on the functioning of payment systems, while commerce regulators, like the Federal Trade Commission, were poorly equipped to handle the complexities of financial markets.
Further, the Fed had been given oversight of Truth in Lending in 1968, a congressional compromise that placed this authority with a business-friendly regulator. Senator William Proxmire, the driving force behind TIL and bankcard regulation during this period, also hoped the Fed would establish rules for lenders to determine consumers’ credit-worthiness before issuing credit cards. The Fed, though, proved a reluctant regulator, and Fed officials succeeded again in talking their way out of any significant role in the bank credit card industry.
he transition from credit cards to debit cards was a rocky one for banks and the interchange networks. The interchanges hoped to harness the payment systems technology that undergirded bank credit cards to facilitate other types of transactions. In particular, interchange executives like Visa’s Dee Hock envisioned payment cards replacing all other money mediums, as computers and electronic accounting promised to usher in a “cashless” and “checkless” society. In Hock’s vision, the interchanges would preside over this electronic future, organizing the virtual exchange of value between consumers and the rest of the economy.
Yet large banks like Citibank and Bank of America had a different vision of paperless payments. As the credit card industry developed through the cooperative interchanges, these institutions also invested in proprietary technologies that facilitated the electronic transfer of funds. Large banks hoped to capture increasing consumer market share through bank-owned ATMs and other bank-offered services, not through cooperative systems like Visa and MasterCard. These banks created ATM cards, which did not, at first, provide access to the interchange networks or enable purchases like debit or credit cards do.
Thus, although Visa and MasterCard introduced debit card products in the mid-1970s and early 1980s respectively, they had difficulty convincing large banks to offer debit cards to their customers, since these products seemed to compete with the bank-owned systems. Smaller banks were more receptive, since they could not afford to invest in the technology pioneered by the large banks. But because they had limited market share, it was difficult for them to convince enough consumers or merchants to adopt debit cards. This was also true for the Thrifts, the collective name given to smaller financial institutions like savings-and-loans and credit unions, which were only given regulatory approval to issue card products in 1980.
Further, debit cards, which carried an interchange fee, seemed to offer merchants little improvement over checks, which had long had free par clearance facilitated by the Fed. If debit cards were equivalent to checks—and in the early 1990s Visa even called its debit card product Visa Check—then why should merchants have to pay to accept them? Although Visa and MasterCard charged merchants lower discounts on debit card transactions (consisting of a fixed charge plus a smaller percentage of the purchase price) than for their credit card products, merchants nevertheless resented these fees.
Thus debit cards did not enter mainstream usage until the 1990s, and only did so once Visa and MasterCard convinced the large banks to adopt these products. As David L. Stearns argues in his recent book, Electronic Value Exchange, which explores the development of the Visa system, only then did banks replace their proprietary ATM cards with Visa and MasterCard branded debit cards, which would both draw cash at ATMs and purchase goods from merchants. One big reason banks came to promote debit card products was that the interchanges, led by Visa, ratcheted up interchange fees. This was especially the case for signature debit, where a customer signs for a debit purchase, instead of PIN debit, where a customer punches in a personal identification number.
Despite their reluctance, merchants who accepted Visa and MasterCard credit cards were initially forced to accept the debit card products as well. Merchants had signed contracts that obligated them to accept any card issued under these brands (the “honor all cards” rule), and they did not want to give up credit card customers just to avoid debit card interchange fees. Since debit cards initially represented a fraction of consumer bankcard use, merchants swallowed their complaints and accepted the new card products.
Consumer debit card use grew, however, and eventually major retailers, led by Walmart, filed an antitrust claim against the interchanges, arguing that honor-all-cards was an unlawful restraint of trade. The interchanges settled and amended their rules, but the conflict over debit card fees continues.
hese, then, have largely been the battle lines drawn between merchants and banks on the debit card interchange issue, with both sides hoping to sway consumers, regulators and, most recently, Federal judges. Banks will claim that lost revenue must be reclaimed through new consumer debit card fees, while merchants will claim that the current system leads to higher consumer prices and, all told, less aggregate demand.
Ultimately, both banks and retailers came to realize that the debit card payment system has costs, and each now wants desperately to push those costs onto the other. What has emerged, as the retailers’ suit against the Fed illustrates, is a kind of positional arms race in which everyone loses from higher transactional costs that are mostly gratuitous. That is why, in assigning the task of regulating interchange fees to the Federal Reserve, Congress chose the correct regulator but gave it the wrong instructions. After 1913 the Federal Reserve created a quasi-public check clearing system that competed with private systems and ultimately eliminated check discounting. It should perform a similar function for debit card transactions, and perhaps credit cards—the function BankAmericard asked it to serve in the early 1970s.
This solution would cost the banking industry a significant source of revenue, but it would also force consumers who use debit cards to bear the costs more directly as banks restructure their fees. That dynamic is preferable, on grounds of both fairness and efficiency, to spreading those costs indirectly through higher retail prices for everyone. To a certain extent this is already happening: Many will remember Bank of America’s embarrassing failed bid to ratchet up debit account prices when the Fed initially issued its swipe-fee rule in 2011; fewer will have noticed their banks adding new, more subtle provisions to their checking accounts, like higher minimum balances or required direct deposits. By increasing the costs of consumer accounts in this way, banks are trying to minimize their visibility, and thus their political salience.
Obviously, the key question is “Who pays?” This is always both an economic and a political question, and as payment cards replace Federal Reserve notes and Federal Reserve-cleared checks, the Fed has a duty to ensure that the nation’s payment systems serve all Americans, not just the banks and their interchange allies. The Federal Reserve has the statutory power and capacity to step in and do this, and if it demurs Congress would be wise to force the Fed to assume this function. It is time once again, as Carter Glass argued a century ago, to tear down the toll gates upon the highway of commerce.
Though this is by far the best solution to the problem for the nation and the economy as a whole, it seems politically difficult, if not impossible, to achieve at the present time. The Fed cannot, or at any rate will not, provide a common good for the economy in 2013 as it did just after 1913. Why is that?
Answers to such questions tend to devolve into lists: present political alignments, the state of public utility theory, the lack of “capital P” Populism. But the problem is really both simpler and deeper than that.
Consider that in facilitating check clearing, the Fed sought to remove profit from the nation’s predominant payments system so that money could move across time and space without lining pockets in between. Now, however, the dominant form of money itself is a thing that is owned. Visa and MasterCard are brands owned by investors as well as forms of payment facilitating commerce; cash and checks are the latter but not the former. Very few consumers recognize or understand this difference, and so fail to appreciate their political stakes in the money system. Only when they do understand them will they refuse to be the chit pushed back and forth between merchants and bankers and begin to hold lawmakers and regulators accountable to the needs of the nation and the economy as a whole.