A Lower Debit Card Interchange Fee Cap is Unlikely to Eliminate Durbin Amendment Fee Increases Plaguing Small-Ticket Merchants

By Stephen J. Shapiro

The Durbin Amendment to the Dodd-Frank Act required the Federal Reserve to ensure that debit card interchange fees are “reasonable and proportional to the cost incurred by the [debit card] issuer with respect to the transaction.” Therefore, the Federal Reserve issued regulations, which became effective on October 1, 2011, that capped interchange fees on debit cards issued by banks subject to the Durbin Amendment (those with more than $10 billion in assets). Under the formula in the regulations, the interchange fee for the average debit card transaction of $40 would not exceed 24 cents, which is about half the amount that issuers had charged for the same transaction pre-regulation.

The regulations had an unintended consequence:  Merchants who sell small-ticket items actually saw their interchange fees increase. As explained in a paper by Zhu Wang, an economist at the Federal Reserve Bank of Richmond:

“Prior to the regulation, Visa, MasterCard, and most PIN networks offered discounted debit interchange fees for small-ticket transactions as a way to encourage card acceptance by merchants specializing in those transactions. For instance, Visa and MasterCard set the small-ticket signature debit interchange rates at 1.55 percent of the transaction value plus 4 cents for sales of $15 and below. As a result, a debit card would only charge a 7 cents interchange fee for a $2 sale or 11 cents for a $5 sale. However, in response to the regulation, most card networks eliminated the small-ticket discounts, and all transactions (except those on cards issued by exempt issuers) have to pay the maximum cap rate [of no less than 21 cents] set by the Durbin regulation. For merchants selling small-ticket items, this means that the cost of accepting the same debit card doubled or even tripled after the regulation.”

Shortly after the regulations went into effect, several merchant trade associations sued the Federal Reserve, arguing that the interchange fee cap was too high because the Federal Reserve did not properly implement the Durbin Amendment. Specifically, the Durbin Amendment identifies two categories of costs incurred by debit card issuers: (1) specified costs that the Federal Reserve could consider when setting the fee cap, and (2) specified costs that the Federal Reserve could not consider when setting the fee cap. In preparing the regulations, the Federal Reserve considered a third category of costs – costs not specified within either of the first two categories – and included some of those costs in the formula it used to calculate the fee cap. The merchants argued that, under the plain terms of the Durbin Amendment, the Federal Reserve only was permitted to consider costs within the first category when calculating the cap and, therefore, its inclusion of costs from the third category was improper and resulted in an inflated fee cap.

On July 31, 2013, the United States District Court for the District of Columbia agreed with the merchants and vacated the regulations in NACS v. Board of Governors of the Federal Reserve System. Among other factors that the Court offered in support of its conclusion, the Court mentioned the small-ticket merchant issue:  “By including in the interchange fee standard costs that are expressly prohibited by statute, the final regulation represents a significant price increase over pre-Durbin Amendment rates for small-ticket debit transactions . . . . Congress did not empower the Board to make policy judgments that would result in significantly higher interchange rates.”

The Federal Reserve has indicated that it intends to appeal the Court’s ruling, but assuming that the Federal Reserve eventually is required to lower the debit card interchange fee cap, the question becomes, will a lower cap fix the small-ticket merchant issue raised by the Court? Based on the analysis in Dr. Wang’s paper, probably not.

Dr. Wang explained that, pre-regulation, issuers were willing to reduce interchange fees for small-ticket transactions because those transactions acted as loss leaders. After the regulations went into effect, though, the economics no longer worked:

“Before the regulation, card networks were willing to offer discounted interchange fees to small-ticket merchants because their card acceptance boosts consumers’ card usage for large-ticket purchases from which card issuers can collect higher interchange fees. After the regulation, however, card issuers profit less from this kind of externality, so they discontinued the discounts.”

If Dr. Wang’s understanding is correct, a reduction in the interchange fee cap will not solve the small-ticket merchant problem. To the contrary, a reduction in the cap would make it even less likely that issuers will reinstate small-ticket merchant discounts because the reduced cap would further diminish the economic incentives that led issuers to offer the discounts in the first place. To be sure, lowering the fee cap will reduce the fees that all merchants – including small-ticket merchants – pay when compared to the fees changed under the existing regulations. However, fees will not return to the low levels small-ticket merchants paid pre-regulation (unless, that is, the cap for all merchants is lowered to the pre-regulation discounted rate for small-ticket merchants – a result that seems highly unlikely).

Dr. Wang’s report also exposes a potential flaw in the NACS Court’s analysis. The Court’s conclusion that the regulations did not adhere to the Congressional intent behind the Durbin Amendment because they resulted in increased interchange fees for small-ticket merchants suggests that it may have overlooked the economics upon which the small-ticket merchant discounts were based.