The Federal Reserve issued its proposed rule on interchange fee limits today. The regulation stems from requirements in Dodd-Frank and looks about as draconian as feared:
The Fed is seeking comment on proposals that could limit interchange fees to an initial level of 12 cents per transaction. According to the Fed, the average interchange fee is about 44 cents per debit transaction, or 1.14% of the transaction amount.
An interchange fee is the technical term for what banks charge retailers when you use your debit card. Whether at the local food mart or a high end clothing boutique, banks collect a certain percentage of each sale in order to fund the debit card system. There are costs associated with issuing and maintaining cards, personnel for systems management and security, fraud prevention, etc. Banks do pull in a nice profit from these fees as well, but they are a natural part of the system.
While debit card fees had nothing to do with the financial crisis—other than plastic cards making consumers more likely to spend money than with cash—they were attacked in the catch all Dodd-Frank bill that was mostly an attack on the financial sector wherever the vindictive could reach.
Consumer advocates argue that consumers pay higher prices as a result of the fees, and thus they should be lowered. Marketwatch quotes Ed Mierzwinski, consumer program director for the U.S. Public Interest Research Group, saying "The system is a mess, and all consumers pay more at the store and more at the pump because merchants are forced to raise prices."
But this is incredibly short-sighted.
Consumers get a lot of "free" services because of the interchange fee receipts. Free checking accounts and free debit cards are finances with those fees. Why should a bank let you keep money with them, give you a card to spend money one, replace it as needed, and offer you fraud protection, all for free? They don't. They can't. They can either charge you fees directly or go the interchange fee route. If you restrict fees as the Fed has proposed, banks will be losing hundreds of millions of dollars—and they will have to make that up by charging consumers higher fees.
Consumers also get a number of services and rewards programs today that do not fund themselves. Banks will also look to pull back rewards programs that gave cash back or built up points or airline miles that amounted to free stuff—all for the minuscule price of a few cents per transaction in an interchange fee.
We've already seen an example of this happening with credit cards. The CARD Act limited what credit card companies could charge in interest rates, so credit was pulled back, fees were increased, and consumers took the hit. The same thing will happen with debit cards if this rule goes forward.
Think about it like this: If you are PNC or Wells Fargo, and this rule goes in place, and you lose hundreds of millions in revenue by being forced to lower your interchange fee to a below market rate, what will you do? The debit card system is in some ways a closed cycle. You won't pull resources from other parts of the institution to cover a program that is now experiencing a loss. You will make up for the lost revenues with new fees, higher current fees, higher penalties, or reduced benefits. It would also be fair to assume that innovative programs in this realm would cease.
As we cited earlier this year, Australia experienced such an even when regulators capped interchange fees in 2003:
"Annual fees increased an average of 22% on standard credit cards and annual fees for rewards cards increased by 47%-77%. Card issuers also reduced the generosity of their reward programs by 23%. Innovation, especially in terms of improved security and identity-theft protection, was stalled. Card issuers also increased their efforts to attract higher-risk customers who generate interest and penalty fees to offset lower interchange revenues from lower-risk transactional users."
That is truly frightening. That is what getting protected to death looks like.