THE UNANTICIPATED COSTS AND CONSEQUENCES OF FEDERAL RESERVE REGULATION OF DEBIT CARD INTERCHANGE FEES

The following information was released by the Progressive Policy Institute (PPI):

Robert J. Shapiro

Jerome Davis

Americans currently use debit cards and credit cards for nearly 82% of their payments and purchases, almost double the share as recently as 2003. In 2022, they used debit cards 98 billion times for payments totaling $4.34 trillion and credit cards 55.3 billion times for payments totaling $5.42 trillion.

The U.S. economy now runs on electronic payments, and every purchase and sale depends on an intricate network that involves not only consumers and merchants, but also the merchants' banks, the banks that issue the debit and credit cards and maintain their cardholders' accounts, and network processors such as Visa and MasterCard that intermediate the electronic exchanges.

Merchants bear much of the costs of this payment system through "interchange fees" they pay to the card-issuing banks and network processors. The network processors, working with the card- issuing banks, set the fees for credit card sales using formulas that depend on the value of the sale and the credit lines and rewards provided by the issuing bank. Under the Dodd-Frank Act of 2009, the Federal Reserve caps interchange fees for purchases by debit cards issued by large banks (assets of $10 billion and more) based on a baseline fee of 21 cents, 0.05% of a sale's value, and a 1-cent charge to cover banks' fraud prevention operations.

The regulation creates large disparities in a sale's interchange fees based on whether the consumer makes the purchase with a debit card or a credit card. For a $40 retail purchase with a Visa or MasterCard debit card, merchants pay and card issuing banks receive a fee of 23 cents, versus fees of 67 cents to 94 cents for the same $40 sale using a Visa or MasterCard credit card.

The debit card fee cap is intended to lower retail prices based on merchants passing along their interchange fee cost savings to consumers. It has not happened: A thorough review finds that several developments have precluded merchants from passing along such savings to consumers. Firstly, the savings are much less than expected. The Federal Reserve formula produced no savings for small debit card sales of $5 or $10; instead, the baseline fee produces interchange costs for such purchases that exceed the average profit margins for retail operations. The regulation also led cardissuing banks to recoup some foregone revenues from debit card transactions by enhancing the appeal and use of their credit cards, and increased credit card use with higher, unregulated interchange fees from this dynamic and other changes have offset much of the merchants' savings from the capped fees for debit card sales.

The net savings from regulating the interchange fee costs only for purchases by debit card and the increased credit card use cannot support any meaningful price cuts for all purchases, and charging less only for debit-card sales would alienate credit card and cash customers. While merchants are legally permitted to offer discounts, the Federal Reserve Bank of Atlanta reports that merchants in 2023 provided discounts for only 2.6% of payments by debit card, 3.6% of cash payments, and 4.5% of credit card payments.

According to a survey of merchants one year after the regulation took effect, 1.2% passed along any savings, 21.6% raised their prices, and 77.2% made no price adjustments. Drawing on another decade of evidence, a series of economic studies have found that the cap's impact on consumer prices "appears negligible," finding "little evidence" of any consumer savings or that any benefits were "unmeasurable."

Analysts also find that the cap led to unanticipated increases in bank fees and charges. The case for the regulation focused on the dynamic between a merchant's costs for a debit card sale and consumer prices, but electronic payments occur in a "two-sided market" that also involves exchanges between merchants and the banks that issue debit and credit cards and manage their cardholders' accounts. The card-issuing banks subject to the cap responded to their foregone debit card interchange revenues by increasing other consumer charges for monthly accounts, overdrafts, and ATM use, and by limiting access to no-fee accounts.

Banks also enhanced the consumer appeal for their credit cards with higher, unregulated interchange fees by increasing the rewards and cashback payments they provide for using their credit cards. Based on changes in how consumers pay for their retail purchases, it apparently worked. By total numbers, the share of retail sales by credit card nearly doubled from 2012 to 2024, while the share of cash payments fell by more than half, and the share by debit card increased little. Measured by the total value of retail payments, the share by credit card also jumped sharply, while the share by cash payments fell substantially, and the share by debit card declined. As the number and value of cash retail sales fell sharply in this period, new credit card inducements likely attracted many former cash-paying consumers.

The use of credit cards with rewards and cashback payments does clearly differ by household income: Less than half of Americans with incomes under $25,000 have credit cards, compared to 89% of those with incomes of $50,000 to $100,000 and 97% with incomes over $100,000. Data also show that 90% of Asian Americans and 86% of White Americans have credit cards, versus 70% of Black Americans and 74% of Hispanic Americans.

Even so, access to reward cards is based mainly on credit scores, not incomes. A 2018 study from the Federal Reserve Board found only a modest correlation between income and credit scores, a finding supported by a later study issued by the American Bankers Association. The authors of the Federal Reserve analysis further established that credit scores at every income level range from excellent to poor, confirming that "income is not a strong predictor of credit scores, or vice versa.

The two-sided market dynamics in banking charges, however, have disproportionately burdened lower-income and minority Americans. Higher banking fees based on a threshold monthly balance affected 70% of accountholders in the lowest income quintile versus 3% in the highest quintile, and the number of households citing high bank account fees as a reason for not maintaining a bank account jumped 81%. As a result, the unanticipated effects of the debit card regulation on banking fees and access to bank accounts created a barrier for some lower-income households to establish sound credit scores needed for bank loans, as well as access to credit cards with rewards and cashback payments.

Drawing on a decade of evidence, we can also gauge the impact of the debit card cap and the two-sided market dynamics on merchants' total interchange fee costs. First, we measured the growth trends in debit card and credit card use in the years leading up to the cap and applied those trends to their use from 2012 to 2022 under the cap. In this alternate scenario, based on relative growth rates prior to the cap, debit card purchases in 2022 would have been $1.4 trillion greater, and credit card purchases would have been $1.4 trillion less.

To estimate the accompanying effects on merchants' total interchange costs, we determined the current average credit card interchange rate and the current average rate for debit card sales issued by banks exempt from the cap as a proxy for the unregulated debit card interchange rate. Next, we applied those rates to the alternate scenario. This analysis found that under the alternative scenario, the cap and market responses reduced merchants' debit card interchange costs in 2022 by $37.4 billion while their fee costs for credit card sales increased by $25.2 billion. This tells us that the increased use of credit cards, with their higher interchange fees, offset 67.4% of merchants' cost savings from the cap on debit card interchange fees. In addition, the major beneficiaries of the net savings have not been local merchants and their customers but large national retail chains and their shareholders. Sales by retailers with revenues of $100 million and more account for 72.5% of all consumer purchases, including 54% of retail sales by chains with more than $2.5 billion in annual revenues,19 and the 10 largest U.S. retailers alone account for nearly 30% of all retail sales.

Despite these lessons from the regulation of debit card interchange fees, Congress is considering another proposal to help consumers by lowering merchants' credit card interchange costs. The proposal would require that merchants choose between using the Visa or MasterCard processing network or their smaller competitors, before transacting each credit card sale. Given the extensive experience and analysis of unintended adverse effects from capping debit card interchange fees, this change is also unlikely to benefit American consumers.