Bankruptcy

Small Banks and Debit Interchange Reform: Winners or Losers?

By Adam Levitin

The banking industry is making a full court press to get the Durbin Interchange Amendent implementation delayed. Given that a year of delay is worth about $15-16 billion in swipe fees, the banks are quite motivated, and they've managed to get legislation introduced to delay the rule-making so the Fed can study the issue further.  

A potent force in attempts to delay the Durbin Amendment's implementation are community banks and credit unions. While most debit swipe fees go to a handful of very large banks, small banks have been quite concerned about the impact of the Durbin Amendment. And community banks and credit unions carry outsized political influence because of their presence and standing in every community. The local Chambers of Commerce and Rotary Clubs, etc. are filled with the CEOs of community banks and credit unions, not the local branch managers of Bank of America or Citibank.  

But are the small banks right to be so worried about the Durbin Amendment? It's not so clear, and a recent American Banker reader poll indicated that a majority of readers thought that small banks would actually benefit from the Durbin Amendment (I've made a similar argument about credit unions benefitting from the CARD Act.) The Machiavelli of the card industry himself, Andrew Kahr, even opined in the American Banker that small banks would benefit from Durbin. In his words, the claim that Durbin hurts small issuers is "Poppycock." It's pretty hard to argue with Kahr's math, when it observes that it can only help small banks if they get 100bps vs. 30bps for the big banks. So what gives?

Small issuers are rather dependent on debit interchange revenue, in the sense that many of them do not to have huge profit margins, and a serious reduction in debit interchange revenue could threaten their profitability. (I did a study on this looking at credit unions, but I suspect community banks are in much the same boat). Of course, no one ever said that there's a right to make a profit through uncompetitive business practices (although that does seem to be the working assumption of the Wall Street Journal editorial page--are they even aware of the economic crisis caused by banks run wild?), and if banks fail because they can't compete, isn't that just the free market and all that jazz? Or does that argument only apply to nonfinancial firms?

In any case, here's why the Durbin Amendment probably doesn't harm small banks and likely helps them. The Durbin Amendment has two moving parts. Part one caps debit interchange fees at reasonable and proportionate to incremental cost of individual transactions. (The Fed very generously thinks this is in the 7-12 cent range.) Part two mandates that there be at least to networks competing for the routing of each transaction, with the merchant deciding on the routing (presumably selecting the cheaper option). In essence, part one would put a ceiling on fees, and part two would foster price competition beneath the ceiling as networks try to maximize market share. 

The Durbin Amendment contains an exemption for small issuers, defined as issuers with less thna $10 billion in consolidated net assets.  This covers 99% of financial institutions, but only a miniscule share of the dollar volume of the debit market on the logic that small issuers don't have market power and aren't creating the antitrust problems in the debit space. (Not surprisingly, Richard Epstein thinks this is an unconstitutional disparate impact...) The small issuer exemption applies only to part one of the Amendment--the price cap. It does not exempt them from part 2.  In other words, fee caps do not apply to small banks, but general competition does.

The question, then, is what will happen to interchange fee revenue for small issuers? That is largely dependent on two things. First, will there be two-tier or one-size-fits all interchange fees? And second, what will be the impact of routing competition? We know the answer to the first question, I think. It seems pretty clear now that there will be two-tier interchange fees. Visa has announced it will have a separate set of interchange fees for small banks. Several other networks have also indicated this (MasterCard has not, but it's hard to imagine that they won't, as they tend to copy Visa's pricing and, more importantly, can't afford to lose debit market share to Visa). So small banks will not end up under the Durbin interchange rate cap as a de facto matter.

Now that doesn't mean that they'll retain their current level of interchange fees, and that's their real concern. But I think there's a good chance that they will retain the current fee level. The networks have no incentive to lower interchange fees for small issuers--instead, their long-standing incentive to raise fees as part of competition to sign up issuers still remains. So putting aside Part 2 of the Amendment for the moment, I don't think there's much for small issuers to worry about.

But of course we do need to consider part 2.  We don't know exactly how the routing competition will work under the Durbin Amendment rulemaking. It's possible that there will have to be just 2 networks on each card or that there would have to be two networks capable of performing each transaction type on each card (2 PIN/2 signature or 2 PIN/0 sig or 0 PIN/2 sig).   I think the latter reading is the one consistent with the text of the Amendment and the policy goal encapsulated therein, but we don't know what the Fed will do here.

If the Fed opts for a weak reading of the Durbin Amendment, I don't think we'll see very strong price competition beneath the part 1 price cap. If so, there's not much for small banks to worry about overall.  

But if the Fed opts for the strong reading of the Durbin Amendment, then we will have some real price competition beneath the part 1 price cap. The question, then, is whether the networks care more about signing up issuers or about winning the routing on a particular transaction. I don't know what the answer is. If the network doesn't sign up the issuer, it's not even in the game for the transaction routing, but unless it gets the transaction routing, the network gets nothing. My best guess is that these competitive forces more or less blunt each other, meaning that we aren't likely to see major movement in interchange rates for small banks, irrespective of how the Durbin Amendment rulemaking plays out.

Maybe someone has a more advanced model of this, however--I'm all ears.  If I'm wrong about the impact of part 2, perhaps it suggests that the fix is just to exempt small issuers from the routing provisions of part 2.  

What I think this all means, then, is that the Durbin Amendment might actually be a real boon to small banks and credit unions, as it will start to level the playing field in the card space relative to the handful of megabanks that dominate consumer finance. There are lots of economies of scale in the card space, and the small banks are at a disadvantage because of that. But if they end up with higher interchange revenue than big banks as a result of Durbin, that is a step toward undoing the troubling consolidation of financial services around too-big-to-fail institutions. All in all, I think it's quite likely that small banks come out ahead under the Durbin Amendment, which is a reason to support it. 

Final, unconnected observation: nothing in Durbin would permit merchants to discriminate on a bank-by-bank basis. The idea that merchants wouldn't take small banks' debit cards is just silly. It'd violate their agreements with the card networks and would involve either (1) BIN recognition or (2) physical examination of cards at POS by cashiers. The first isn't possible currently, and it's hard to imagine a merchant that wants to bother with the second and tick off customers. 

Full post as published by Credit Slips on March 16, 2011 (boomark / email).