Debit card interchange fees are paid by merchants to issuing banks for processing debit card transactions. The fees have been a subject of controversy and regulation in the United States since the 2010 passage of the Durbin Amendment to the Dodd–Frank Act, which authorized the Federal Reserve System to cap the fees for large debit card issuers. The cap was put in place in 2011 and currently is about 22¢ per transaction. The Fed now proposes to lower the cap to less than 15¢, which has brought new attention to the rule.

When he introduced the amendment, Sen. Richard Durbin (D–IL) argued that the fees were excessive and unfair, and they imposed a hidden tax on consumers and merchants. Implicit in his argument is the assumption that the debit card market is subject to market pricing power on the debit card supply side that raises interchange fees by constraining card supply.

The Durbin Amendment aimed to address those issues by giving the Fed the power to regulate debit card interchange fees for issuers with more than $10 billion in assets, which account for about two-thirds of all US debit card transactions. The amendment instructs the Fed to ensure that the fees are “reasonable and proportional” to the costs incurred by the issuers for processing the transactions.

Not the Intended Effect

The Fed issued a proposed rule in December 2010 after surveying debit card issuers and networks to collect data on the costs and revenues of processing debit card transactions. The proposed rule offered two alternative approaches for setting the cap on debit card interchange fees: a stand-alone cap of 12¢ per transaction, or a cap based on a formula that considered the issuer’s basic per-transaction costs plus an ad valorem charge.

The proposed rule generated more than 11,000 comments from various stakeholders. There were two main threads: a 12¢ cap was unrealistically low, and the Fed had failed to demonstrate that fees currently being received by debit card issuers were not reasonably related to the costs incurred by each individual issuer. The Fed agreed that the initially proposed 12¢ per transaction fee was too low, and the final rule set the cap at 21¢ plus 0.05 percent of the transaction value and an additional 1¢ fraud-prevention adjustment.

Initial studies following the promulgation of the 2011 regulation focused on the reduction of interchange fees paid by merchants from 50¢ for the average transaction to 24¢ cents, an amount close to the median 21¢ cost of processing debit card transactions. Zhu Wang (2012, p. 168) estimated that the rule resulted in a revenue reduction of between $5.1 billion and $7.4 billion for covered debit card issuers in the year following the implementation of the fee cap, and there was no adverse effect on exempt issuers, both results being as expected. However, Wang found that fee reduction benefits to merchants were not uniformly distributed: merchants whose sales were concentrated in the small (below average) price category received small or even negative benefits, and merchants whose sales were in the high (above average) price category benefited most. Wang attributed this “unintended” consequence to the design of the fee cap: 21¢ per transaction plus 0.05 percent ad valorem (p. 169).

Oz Shy (2012) made a similar observation based on Federal Reserve Bank of Boston Diary of Payment Choice data. According to the author, “The new interchange fee replaces the proportional fees that a cost study conducted by the Federal Reserve Board found on average to be 1.17 percent, or approximately 44 cents per transaction based on the $38 average value of all purchase transactions” in 2012. The new rule allowed issuers to collect proportionately higher fees on small-price transactions than had been the pre-rule practice, and evidence suggested that this possibility was realized to a significant extent. The economic implications of this for social welfare were analyzed by Zhu Wang (2015), who found that reduction in debit card interchange fees in a two-sided market with “ubiquity” externalities might fail to increase social welfare and that lowering the fee cap too much could have a negative result.

Fumiko Hayashi (2013) anticipated this paradox. Social welfare gains from debit card interchange fee reduction could be reduced or negated if affected banks responded to interchange revenue loss by adding demand deposit maintenance fees or by reducing rewards programs for debit cards, which could incentivize consumers to substitute credit cards for debit cards as their payment medium.

While the fee cap saved merchants about 22¢ per transaction, Zhu Wang, Scarlett Schwartz, and Neil Mitchell (2014) found that “less than 10 percent of merchants surveyed reported a decrease in debt costs.” A quarter of respondents reported increased total debit costs, likely related to the small purchase effect on fees discussed previously. Two-thirds reported no change or did not know. It was also noted merchants did not pass on the savings to consumers in the form of lower prices: “The majority of respondents (75 percent) reported no price change due to the regulation. For those who had a price change, 11 times more (23 percent over 2 percent) reported price hikes than cuts.”

Mark Manuszak and Krzysztof Wozniak (2017) found that “banks subject to the cap raised checking account prices by decreasing the availability of free accounts, raising monthly fees, and increasing minimum balance requirements, with different adjustment across account types.” They found that banks are exempt from the cap-adjusted prices as a competitive response to price changes made by regulated banks. These responses to the regulation reduced its potential social benefit and increased its social cost.

Other studies have also found that, despite possible short-run savings to merchants, the interchange fee cap regulation had adverse effects on consumers. Todd Zywicki, Geoffrey Manne, and Julian Morris (2014) estimated that, despite reducing the annual revenue of covered banks by $6 billion to $8 billion, the fee cap led to increased consumer costs because of higher fees on bank accounts, such as monthly maintenance fees, overdraft fees, and ATM fees. They found that the regulation reduced the availability of free checking accounts by 50 percent and increased minimum balance requirements by 23 percent. Moreover, the regulation reduced the incentives for card issuers to offer rewards and benefits to debit card users, such as cashback, points, and discounts. They also found that some issuers also reduced the issuance of debit cards, especially to low-income and unbanked consumers, who are more likely to use debit cards for small-value transactions. Further empirical evidence of these effects is reported by David Evans, Howard Chang, and Steven Joyce (2013), who estimated that the present discounted value of consumer losses because of the Durbin Amendment totals $22–$25 billion and outweighs the benefits from any fee reduction cost savings passed as price increases by merchants.

An expected benefit of the Fed regulation was to increase debit card usage. However, empirical evidence suggests that the regulation may have decreased it. Ben Kay, Mark Manuszak, and Cindy Vojtech (2018) found that the regulation reduced overall debit card usage by 0.8 percentage points and increased cash usage by 0.7 percentage points among low-income consumers, which the authors suggest was because the regulation reduced the availability of debit cards. A report by the Electronic Payments Coalition (2017) also offered numerous surveys and studies showing that the regulation did not lower consumer prices, but that it did reduce access to banking services for low-income households.

Merchants benefit from the expanded customer market created by debit card utilization and customers benefit from convenience. The expanded market compared to a cash-only customer base increases the merchant’s sales revenue and profits and offsets interchange fees and processing network costs. The network effect of an expanded debit card–using customer base also leads to consumer benefits associated with increased efficiency and lower prices. Regulatory interventions like a fee cap can reduce merchant net earnings despite the apparent savings in transaction fees as well as eliminate the network benefits accruing to consumers if it reduces utilization of debit cards. Some studies put little weight on the network effects of reduced debit card use by consumers and thereby underestimate the net welfare loss to society.

The preponderance of the post-regulation literature suggests that the 2011 regulation did not achieve its goals of lowering merchant fees and increasing debit card usage. Instead, the regulation increased checking account fees, increased minimum deposit requirements for free checking, increased ATM fees, reduced or even eliminated consumer rewards programs, and reduced the overall level and growth trend of debit card use. The regulation also had unexpected negative spillover effects on the card networks: the reduction or elimination of rewards programs associated with debit cards may have motivated consumers to switch from debit cards to credit card transactions. Because credit card transactions entail merchant fees that are greater than debit card fees, this substitution effect may have outweighed the savings to merchants from the reduction of debit card fees.

Implicit in the Durbin Amendment argument and the Fed’s regulatory fee ceiling approach is the assumption that the debit card market prior to 2010 was subject to market pricing power on the debit card supply side that raised interchange fees by constraining card supply. Empirical research suggests that the market-power hypothesis underlying the regulatory approach was false. As a result, the regulation may have reduced the social welfare benefits and efficiency of the payment system.

November 2023 Proposed Revision

In November 2023, the Fed proposed to reduce the base component of its fee ceiling formula from 21¢ per transaction to 14.4¢, to which would be added a 1¢ per transaction fraud prevention adjustment (for qualified card issuers) and 0.05 percent multiplied by the transaction amount. The Fed cited a reduction in the average debit card processing costs reported by covered issuers in its biennial survey of covered banks, saying the move will save consumers money.

Based on the average transaction amount of $48.83 for 2022, the current interchange fee ceiling would be about 24¢, less than one-half of 1 percent of the average purchase amount. The effect of the proposed new fee ceiling formula would have resulted in an interchange fee ceiling for the average 2022 transaction of less than 18¢, about a 25 percent reduction in the transaction fee based on the 2022 average transaction amount.

The proposed rule would also automatically revise the basic fee ceiling component biennially, based on its survey of allowable costs relative to transactions processed, without a public notice and comment rulemaking. In effect, the proposed rule would violate long-standing principles of the Administrative Procedure Act. The act requires that no regulatory action be undertaken by any federal administrative agency, including the Fed, without some form of public input opportunity to respond to the proposed action before a final decision is promulgated. This may entail either a formal quasi-judicial hearing or the informal published notice and public written comment process. An exception is provided for bona fide emergency situations, but, even then, the requirement is for a temporary action that cannot be permanently made final until public input has been received and considered.

The requirement for public input is not a matter of simple pro or con voting. It is intended to ensure that substantive knowledge of the facts involved in the decision held by the affected public is revealed and considered by the regulatory agency. Implicit in the Administrative Procedure Act is congressional recognition that administrative agencies are fallible, sometimes not in possession of all the facts needed for a reasoned decision, and perhaps capriciously or intentionally blind to reason. In granting the administrative agencies regulatory power, Congress enshrined public comment as a preliminary check on agency regulatory discretion. When agencies wantonly ignore the public’s right to participate in the rulemaking process, the act provides the federal courts with a basis for review and the rescinding of arbitrary agency decisions. The Congressional Review Act provides an ultimate check on an agency’s abuse of regulatory power. The Fed’s proposal for automatic adjustment of the fee cap without public notice and comment is a blatant attempt to circumvent this clear intent of the Administrative Procedure Act and to avoid oversight of the Congressional Review Act.

The Fed proposed a change in the basic component of the ceiling calculation formula even though almost one in four covered debit card issuers under the current regulation is unable to charge a fee that allows the issuer to fully recover its actual debit card costs. Under the proposed new ceiling, that proportion will rise to one in three. The selection of a benchmark that increases the proportion of covered card issuers who will be unable to recover allowed debit card processing costs is contrary to the approach that the Fed adopted in 2011. Then, the Fed recognized the 12¢ benchmark as unreasonably low and substituted the 21¢ benchmark in the final rule. The 14¢ basic ceiling in the new proposal is equivalent in inflation-adjusted terms to the 12¢ benchmark that the Fed rejected as too extreme in 2011.

The Fed claims the proposed 14.4¢ benchmark would have resulted in 98.5 percent of transactions having covered costs if it were in effect in 2021, but that result is an artifact of the dominance of a few very large low-cost issuers. The important fact is that the proposed lower ceiling will, according to the Fed’s own calculations, increase the proportion of debit card issuers who fail to recover their full costs on some issuers. This result may lead the affected banks to take actions—such as raising demand deposit fees or increasing minimum balance requirements—that will reduce the availability of debit cards to their customers or discourage their use by curtailing rewards programs.

Although consumers are subsidized in the sense that fees are directly paid by merchants, it is not a simple transfer issue to redistribute interchange costs from merchants to consumers. The network effects of this two-sided market imply that raising the share of costs borne by consumers will have a multiplicative adverse effect on the transactions that flow through the merchant’s till. Instead of switching from debit cards to cash or checks, consumers may reduce purchases in the aggregate, resulting in a gross sales loss to merchants that may more than offset any savings merchants enjoy from a reduced interchange fee. Instead of simply transferring a portion of the interchange costs to consumers with a neutral effect on aggregate transactions and social welfare, network effects imply that the redistribution of the fee burden from merchants to consumers may negatively affect total transactions and spending, an effect that has been confirmed by studies of the effects of the 2011 rulemaking. This effect is likely even if merchants pass 100 percent of their transaction fee share savings to consumers in terms of lower prices, which did not occur after the 2011 price cap imposition.

The result of network effects will likely be a net social welfare cost shared by both merchants and consumers. Only under very particular empirical conditions of relative elasticities of merchant and consumer behavior might the outcome be otherwise, and the Fed has not conducted an empirical analysis to prove such a special case. 

The Durbin Amendment and the Fed’s implementation of it are based on an economic analysis that ignores the complexities of markets and network economics.

A fundamental flaw in the Fed’s approach in 2010—which is also inherent in the new proposal—is to rely only on the distribution of card costs of each issuer in relation to one another as the analytical process to set the base component benchmark. The Fed instead should analyze the actual ratio of interchange fees charged to costs incurred at the individual issuer level. The current fee cap formula, based on the median of issuers reported per transaction costs, has the result that 23 percent of debit card issuers recover less than their full costs per transaction, but lower-cost issuers (those whose reported costs are less than the 21¢ base amount) may continue to receive fees in excess of costs. While the reduction in the per transaction base amount in the proposed regulation will reduce the profits of some of the card issuers at the lower end of the distribution, it will continue to allow some of the lowest average cost issuers to collect fees that are variously in excess of costs and simultaneously increase the proportion of card issuers at the higher average cost end of the spectrum who are not allowed to recover their full costs. The Fed’s approach to setting the current cap seems contrary to the explicit intent of the Durbin Amendment that fees be reasonably related to actual costs, and the disparities that the method creates among covered card issuers may have an anticompetitive unintended consequence of promoting greater market concentration within the banking industry.

Finally, it is a fundamental principle of regulatory decision-making that a regulator should consider the benefits and the costs, both direct and indirect, of the proposed approach and feasible alternatives. A rulemaking decision should not proceed unless the regulating agency can demonstrate to a reasonable degree of economic certainty that the benefits of the new rule to society at large will exceed its expected costs. The “Economic Impact Analysis” section of the rulemaking discusses possible benefits and costs in vague terms, but the Fed makes no definitive quantitative or qualitative assertion that expected benefits will exceed costs.

Conclusion

The Fed’s proposed revision to the 2011 regulation capping interchange fees received by covered debit card issuers unreasonably repeats and extends the erroneous approach on which the existing regulation was based. Rather than establishing a standard to ensure each debit card issuer receives an interchange fee that reimburses it for its own reasonable costs, the Fed will make worse an approach that ensures that some issuers are capriciously denied reimbursement of their legally allowed costs.

The Fed has ignored the fact that there is no statutory requirement that it revise its current rule, and its proposal to make automatic future adjustments without notice and comment procedures is an effort to thwart the Administrative Procedure Act and the Congressional Review Act. The Fed ignores the obligation of any rational regulator to make decisions that will reasonably be expected to have economic effects of social benefits that exceed costs. This failure is especially evident in its inadequate analysis and consideration of the important network effects embedded in the electronic payments market. The latest proposal by the Fed is the culmination of a history of flawed regulatory actions.

Readings

  • “Competition and Complementarities in Retail Banking: Evidence from Debit Card Interchange Regulation,” by Benjamin S. Kay, Mark D. Manuszak, and Cindy M. Vojtech. Journal of Financial Intermediation 34: 91–108 (2018).
  • “Debit Card Interchange Fee Regulation: Some Assessments and Considerations,” by Zhu Wang. Federal Reserve Bank of Richmond Economic Quarterly 98(3): 159–183 (2012).
  • “Durbin Amendment: Five Years of Higher Costs and Broken Promises.” Electronic Payments Coalition, 2017.
  • “Price Cap Regulation in a Two-Sided Market: Intended and Unintended Consequences,” by Zhu Wang. Federal Reserve Bank of Richmond Working Paper Series, WP 13–06R, December 2015.
  • “Price Controls on Payment Card Interchange Fees: The U.S. Experience,” by Todd J. Zywicki, Geoffrey A. Manne, and Julian Morris. International Center for Law and Economics, White Paper 2014–2.
  • “The Impact of Price Controls in Two-Sided Markets: Evidence from U.S. Debit Card Interchange Fee Regulation,” by Mark D. Manuszak and Krzysztof Wozniak. Finance and Economics Discussion Series 2017-074. Washington: Board of Governors of the Federal Reserve System, 2017.
  • “The Impact of the Durbin Amendment on Merchants: A Survey Study,” by Zhu Wang, Scarlett Schwartz, and Neil Mitchell. Federal Reserve Bank of Richmond Economic Quarterly: 100(3): 183–208 (2014).
  • “The Impact of the U.S. Debit Card Interchange Fee Regulation on Consumer Welfare: An Event Study Analysis,” by David S. Evans, Howard Chang, and Steven Joyce. Coase–Sandor Institute for Law & Economics, Working Paper No. 658, 2013.
  • “The New Debit Card Regulations: Effects on Merchants, Consumers and Payment System Efficiency,” by Fumiko Hayashi. Federal Reserve Bank of Kansas City Economic Review 98(1): 89–118 (2013).
  • “Who Gains and Who Loses from the 2011 Debit Card Interchange Fee Reform?” by Oz Shy. Federal Reserve Bank of Boston Public Policy Discussion Papers No. 12–6, version of June 19, 2012.