Dodd-Frank’s Dire Legacy: The Durbin Amendment

Today is the fifth anniversary of the passage of the Wall Street Reform and Consumer Protection Act, better known as Dodd-Frank. As the Mercatus Center revealed this week, it may be the biggest law ever written, because it gives the administration so much discretionary power to make secondary law. It has harmed consumers by reducing choice in financial services and failed to solve the problems it was purported to solve, as I outline in my new paper, How Dodd Frank Harms Main Street. One of the worst examples of this stems from the Durbin Amendment, a last minute addition to the bill that gives the Federal Reserve the power to cap interchange fees  charged by debit and credit card networks.

An interchange fee is a facility fee paid by a merchant when a customer pays using an electronic card network like MasterCard or Visa. The customer gets the convenience of using a card rather than cash, the merchant gets paid with protections against fraud, the card issuing bank gets an incentive to keep issuing the cards, and the card network gets some money to reinvest in improving the efficiency and security of its network. The merchant, bank, and network all get some profit and the customer gets an item of value. All parties see some gain from the trade.

So far, so much Adam Smith. Yet unfortunately merchants all over the world bridle at having to pay the fee. In yet another example of Bastiat’s “seen and unseen,” they see the fee and have formed powerful lobby groups all over the world aimed at persuading governments to impose limits on the fees.  Merchants argue they will be able to cut prices once a cap is introduced and that the fee is a hidden charge on the  consumer.

These arguments won the day during the passage of Dodd-Frank, with Illinois Senator Dick Durbin (D-Ill.) sponsoring a “midnight” amendment to impose caps on debit card interchange fees. Note that interchange fees had nothing whatsoever to do with the financial crisis. They are not a destabilizing element in the financial system (if anything, they are the reverse, providing a secure transaction-based revenue stream that is used to improve financial security). The political atmosphere at the time was such that anything that punished “bankers” in the name of helping the little guy was going to go through, and so it did.

The irony is that Main Street banks issue debit cards to the little guys while Goldman Sachs et al only give them to their superwealthy clients. The Dubin Amendment would hit Main Street banks and their customers hard, as my colleague John Berlau suggested shortly after it passed. He noted that free checking would be the first thing to go as bankers moved to make up these lost revenues.

And so it proved. Surveys demonstrated that as soon as the Durbin Amendment was passed – even before it went into effect – banks started raising fees and cutting back on free services. The lobby group for continued controls has argued that this cannot have been an effect of Durbin because the law had not got into effect. Yet, people react to what they know is going to happen, and don’t wait until the day of effect to act. The result has been that poor bank customers have been hit hard, with a million people forced out of the banking system as a result of increased fees.

There is actually a natural experiment on the effects of interchange fees caps. The Durbin Amendment exempts small banks of under $10 billion in assets from the fee cap. Those banks have not needed to seek revenues elsewhere and so continue to offer free checking and other services. Bizarrely, some people argue that the continued existence of these services validates the need for interchange fee caps and that the amendment did not increase bank fees.

Worse, merchants have yet to pass on their reduced cost to customers. Survey after survey finds that merchants simply kept the reduced cost as a windfall. Even the most generous survey for the merchants finds that the costs to consumers from increased bank fees outweighed the modest cost reduction they saw from highly competitive merchants. Main Street banks and the little guy have been hardest hit.

Not even all merchants benefitted. Prior to Durbin, most banks gave a discount on interchange fees to small ticket merchants who generated most of their revenue through low-cost items. These discounts were eliminated in response to Durbin. That’s why Starbucks invested heavily in Square, the card and phone app that allows card payments at a much higher fee than the interchange cap allows (which is possible because Square itself is a merchant).

The Durbin Amendment's damage has not been confined to the U.S. Following America's lead, both the European Union and Australia are moving toward much heavier regulation on both debit and credit card networks. In the EU, the regulations will impose a fee cap and separate payment companies and their networks, meaning that more companies would be involved in the process,  increasing both the weak points in the system and information costs. And higher-cost cards like American Express have a temporary exemption, which belies the argument that this is about leveling the playing field.

In Australia, there is a class warfare element to the proposed regulations (which build on existing caps), with proponents claiming that no-frills credit card holders are subsidizing expensive rewards cards through the fees. Never mind that interchange fees just killed the last major debit card rewards program in the U.S. If anything, U.S. interchange fee caps have reserved rewards programs for rich credit card holders.

Americans should watch what happens in Australia. The effects of further fee caps on credit cards Down Under are likely to severely restrict Australians’ access to credit and increase the pressure of people who are financially stressed. (To learn more, see the International Alliance for Electronic Payments web campaign here).

So if your bank fees have gone up in the last five years, if you’ve lost a debit cards rewards program you loved, or if you no longer have free checking, thank Dodd-Frank, and remember July 21 each year.