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Look What Congress Just Did to the Debit Card Market

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Like most of us, I want to see Congress pass a strong financial reform bill. I want it to have teeth. End too big to fail. Curtail systemic risk. Restrain leverage. I want to let Wall Street know that it is, as one Fool put it, sunset for the sociopaths.

And for the most part, it does. But for one section of the bill, what began as a valiant attempt to score points for consumers and small businesses may end up haunted by unintended consequences.

I'm talking about the regulation of debit-card interchange fees -- 1%-3% licks off the top of every purchase you make with a debit card, paid by merchants.

A little off the top
Here's how it works: Say you make a $100 purchase at the grocery store, paid on your debit card. For the privilege of processing the transaction, the grocer owes the card processor -- usually Visa (NYSE: V  ) or MasterCard (NYSE: MA  ) -- between $1 and $3 in interchange fees (plus a few other nominal fees for service). That's the cost of doing business. Visa and MasterCard then remit substantially all interchange fees back to the bank that issued you the card. Today, Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , and Wells Fargo dominate this market.

For retailers with sliver-thin margins, interchange fees can be deadly serious. Costco (Nasdaq: COST  ) , for example, doesn't allow customers to pay with anything other than cash, check, pin-based debit (different than so-called signature debit) ), its own self-branded credit cards, or American Express (NYSE: AXP  ) , which negotiated a special deal in exchange for exclusivity in 1999. That lets Costco avoid most interchange fees and keep retail margins extremely low, which is how its business model works.

But most retailers could never get away with this, and many get gutted by interchange. Basically, anything with less than 3% margins can have all profits wiped out after interchange.

So merchants stomped their feet loudly, and Congress listened. Seeing the card market as the near monopoly that it is, the new financial reform bill will allow the Federal Reserve to determine what is "reasonable and proportional to the actual cost incurred" when it comes to debit-card interchange fees. Undoubtedly, the Fed will determine that "reasonable" is a fraction of what's charged today.

One fee, two fee, red fee, blue fee
Who wins here? It's hard to tell, and not as obvious as it appears. You might think retailers will score big. And they may. But the retail industry is so ferociously competitive that any savings merchants reap from lower interchange fees will probably erode fairly quickly.

Then the customer must win, right? Not necessarily. There are several historical examples of governments forcefully tweaking interchange fees. Few provide much hope. As the Government Accountability Office found of Australia's interchange-fee experiment last decade:

Since Australia's regulators acted in 2003, total merchant discount fees paid by merchants have declined, but no conclusive evidence exists that lower interchange fees led merchants to reduce retail prices for goods; further, some costs for card users, such as annual and other fees, have increased.

I'd focus on that last sentence. The best enlightenment of this proposal's unintended consequences comes from bank analyst Dick Bove, who warns, "You're going to get a letter from your bank saying you now have to pay $1 to $15 a month to pay for this bill."

Now, I know what you're thinking: "Damn those greedy banks!" But this is totally justified.

Consumers have come to expect free checking as a birthright. But banks aren't doing this out of charity. They justify free services by using the cash flow from other areas you may never see, such as interchange fees. That's why they're always begging you to use your debit card more often (check out this ad).

But as soon as interchange fees dry up with the new regulations, banks have to find replacement revenue. You can't blame them for doing this. Believe me -- they aren't making net interest profit on the guy who keeps $500 in his checking account. They have to find a way to make consumer checking profitable. And if it isn't through interchange, then added monthly fees on checking accounts are both assured and entirely defensible.

Careful what you wish for
So in Congress' well-intentioned plan to spare merchants and consumers from the burden of interchange, the end result will likely be a simple shuffling of costs. Unfortunately, it's you, the consumer, that gets shuffled the bad hand and could end up paying the price.

Behold the power of unintended consequences.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. American Express and Costco Wholesale are Motley Fool Inside Value picks. Costco Wholesale is a Motley Fool Stock Advisor recommendation. The Fool owns shares of Costco Wholesale, and has a disclosure policy.

Read/Post Comments (28) | Recommend This Article (44)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 30, 2010, at 1:30 PM, whereaminow wrote:

    Ah, price fixing? No it's worse. That would be a decreed fixed price, which we now will fail (4,000 years of it so far). This is price manipulation, a clever trick, but central planning nonetheless. When this fails it will be the fault of the free market :)

    David in Qatar

  • Report this Comment On June 30, 2010, at 1:33 PM, cmfhousel wrote:

  • Report this Comment On June 30, 2010, at 1:47 PM, outoffocus wrote:

    So first they screw up my credit card, now they are screwing up my free checking. All for one bill that I never asked for and another bill that accomplishes everything but what its supposed to accomplish. Thats our Congress at work.

  • Report this Comment On June 30, 2010, at 1:48 PM, ragedmaximus wrote:

    sometimes i wonder how and why our govt is so broke they get a piece of every slice of pie. look at all the extra taxes on your paycheck ,unemployment check,light bill,phone bill,cell phone,tv,blah blah blah on and on. as an american I enjoy my freedom but with this land of plenty there sure is a hefty price to pay and I don't even like to see the sunday paper anymore ,all it it is b.s. propaganda on all the stupid products I should be buying and don't get me started on all the stupid holidays we have that try to jack your money and the criminals gang members and now terrorist geez what the hell is going on here now we got the stupid russians trying to spy on us good god 2012 and the myan calendar end of days can't get here fast enough. did i tell you i'm completely sick as an oil soaked bird of all the oil spill coverage,call me when the well gets plugged till thin ill just keep watching my stocks get more and more worthless every day and yes my bank swindles 3 dollars a month for overdraft protection !

  • Report this Comment On June 30, 2010, at 2:12 PM, mjmjm wrote:

    Can someone clarify -- do pin-based debit card transactions cost the same interchange as signature-based? Does the legislation address both?

  • Report this Comment On June 30, 2010, at 2:19 PM, cmfhousel wrote:


    Yes, pin is cheaper than signature debit. Per the New York Times:

    "By 1999, Visa was setting fees of $1.35 on a $100 purchase, while Maestro and other regional PIN networks charged less than a dime, Federal Reserve data shows. Visa says the fee was justified because signature debit was so much more useful than PIN debit; at the time, roughly 15 percent of merchants had keypads for entering a PIN.

    Merchants said they had no choice but to continue taking the debit cards, despite the higher fees, because Visa’s rules required them to honor its debit cards if they chose to accept Visa’s credit cards."

    As for the legislation, I'm fairly sure it only targets signature debit. I'll look into it some more.

  • Report this Comment On June 30, 2010, at 3:42 PM, gpatrick900 wrote:

    I don’t think the debit card amendment is going to be bad as banks and some experts think.

    This is unconfirmed. I read this on other newspaper sites.

    They changed something’s in the amendment. The rules don’t apply to Federal, State benefit debit cards. So, the Social Security, State Employment and EBT debit cards are excluded from this amendment. So, if you have $1 left you can still use it at the merchant.

    There were some clarifications. Merchants can not choose to accept one banks debit card over another banks debit card.

    The new agency created must included all cost in setting the interchange fee it is not restricted like it was with the original amendment.

    So, the questions is will the government set the fee high enough or two low? That what we got to wait and see. Then we will see if all or some banks add fees to their debit cards and/or checking accounts.

  • Report this Comment On June 30, 2010, at 4:20 PM, ryanalexanderson wrote:

    I often wonder how much of our consumer, debt-laden culture can be attributed to the presence of debit and credit cards. Paying for stuff is waaay more abstract and painless than it use to be. Impulse purchases on crap you don't need are instantly enabled. We consume, and consume, with no barriers except eventual default.

    Maybe a few more barriers between the public and their bank accounts might be healthy in the long term (not the short term, of course). Not that monthly fees would do this. But maybe whatever else the banks have cooking, will.

    ps. this sounds a bit like an old man Luddite rant. I'm in my low-30's. Still, get the hell off my lawn, you damn kids!

  • Report this Comment On June 30, 2010, at 4:57 PM, BMFPitt wrote:

    I don't know why you give Congress the benfit of the doubt and assume they're stupid. Evil at least as much of a possibility for their motivation.

  • Report this Comment On June 30, 2010, at 5:04 PM, ComfortPlayer wrote:

    Two words - Credit Union

  • Report this Comment On June 30, 2010, at 6:27 PM, PositiveMojo wrote:

    Having a czar in place to determine what fees are "reasonable" is ludicrous!

    If anyone runs a business you know that you cannot provide services for free. It costs money to print and manage the security of the debit cards, the network operations centers (which must conform with government regulations), the people to run all of those operations, etc. All of this so that we can use our debit cards.

    You mention Costco - but did you know they sell merchant account services themselves to other businesses? That's right - 2.01% discount fee and $.038 transaction fee. Those nasty bankers!!

    It costs money to do transactions electronically. If the merchants were smart they would offer a deep discount for anyone paying in cash. But how many do? Not many. Hmmm... could this be a consumer behavior issue?

  • Report this Comment On June 30, 2010, at 6:47 PM, cmfhousel wrote:

    Apologies for the confusion: The paragraph beginning "Since Australia's regulators .." is a quote. It should be indented. We'll get it fixed ASAP.

  • Report this Comment On June 30, 2010, at 9:39 PM, xetn wrote:

    The simple solution is for everyone to pay with cash. Then, watch what happens to the fees. Also, watch what happens to the regulation.

    As Thomas Jefferson said: "I believe that banking institutions are more dangerous to our liberties than standing armies."

  • Report this Comment On June 30, 2010, at 10:55 PM, tyhardison wrote:

    Why don't we know if this legislation impacts PIN debit?

    PIN debit networks announce rate increases almost monthly. If PIN debit is exempt we may see banks changing their tune and pushing PIN at the POS. For a long time now, banks have been accused of steering their cardholders to signature to earn higher Interchange. If this is true then merchants can expect this experience repeated in favor of PIN. Will banks simply remove the MasterCard or Visa logo from our debit cards?

  • Report this Comment On July 01, 2010, at 12:56 AM, pkluck wrote:

    Should be a lesson that you don't want the Gov't involved in anything other than national defense, local police and road construction.

  • Report this Comment On July 01, 2010, at 6:08 AM, spenglowe wrote:

    The simple solution is to make the transaction fee part of the customer's cost, printed on the receipt as part of the total. This way we know what we are paying for. All taxes, fees, employee compensation, and other costs to the companies we do business with are passed on to us, the consumer. That's where the money comes from. True reform would be to show the end user where his money is going, instead of hiding it in the form of "merchant fees" and "business taxes". That way we can decide how we want to pay for things.

  • Report this Comment On July 01, 2010, at 10:41 AM, MPov wrote:

    Another point worth noting is that government price controls on interchange fees is going to lead to less innovation in this field. Why should the banks invest in new technology if they can't make money off it? Some may not care but I can remember a time, before all the point of sale technology rolled out, when you had to carry a wad of cash to pay your grocery bill, and stand in line waiting for people to write checks (and for the cashiers to get approval from their manager to accept the checks). The process is much more convenient today and we will miss out on further conveniences in the future. I also wonder whether today's interchange fees are more or less than the merchants were previously paying to handle payment transactions manually.

    I am confident that this is only one of the unintended consequences of the reform bill. Others will show up sooner or later.

  • Report this Comment On July 01, 2010, at 12:11 PM, jrj90620 wrote:

    Thanks to govt deciding that idiot Americans needed a mother to protect them from the evil capitalists at the credit card companies my credit card rewards are fading fast.For years I have earned lots of rewards at the expense of the idiot Americans who paid lots of interest and fees.Now the system will be socialized and I will be a loser.

  • Report this Comment On July 01, 2010, at 12:53 PM, AnotherNavyFool wrote:

    Now this just knocks the cheese off my cracker!

    I am with USAA for my banking and they offer (likely soon to be past tense - thanks Congress!) a 0.5% rebate for using my debit card as a credit card. We get on average $10-$15 a MONTH deposited in my checking account for buying just about everything (gas, groceries, doctor's visits, clothes - everything) each month this way. I have no doubt they can do that because they are getting the 1-3% fom the retailers we buy from. I like the convenience, my wife doesn't worry about having to carry a lot of cash or checks, and it has the same protections of a credit card. Well, I am sure that will go away now thanks to Congress doing something "for my own protection."

    Funny - they can't trust me to make a purchase safely, yet there are no national (or state where I live) laws for mandatory motorcycle helmet use or for trigger locks for handguns. Nasty, dangerous debit card - but hey - guns and motorcycles...rock on, dude!

    Here is how this is going to work out - I will lose my benefit of using the debit card, so I will not any more. Others will do the same. Retailers will pass on the cost of using the cards, but NOT lower their prices accordingly (isn't that always the way?) Thieves will enjoy better success in robbery because more housewives will be carrying cash to pay for $200 grocery bills every week, and we all be slowed in line while stores verify the checks people are going to go back to writing.

    And to make up for the other "perks" we get - free checking, on-line bill paying, etc. - banks will now be forced to charge for those things to make up for lost revenue. I think USAA and credit unions will resist and be the last to do this, but even they must bow to financial considerations.

    Thank you Congress, for "hearing us", but not "listening to us." Thank you for making it more expensive to use my own money. And banks will still be "too big to fail." Wish I were...

    And we didn't even get KY or a kiss...

    -AnotherNavyFool (also in Qatar)

  • Report this Comment On July 02, 2010, at 2:27 PM, ronin424 wrote:

    I want to say, back to cash for me, but even when I pull cash from a bank visit not an ATM visit I still get hit with a transaction fee.

    This isn't a no win situation but one must pick the lesser of 2 evils.


  • Report this Comment On July 02, 2010, at 2:46 PM, belate wrote:

    Anyone stupid enough to use a debit card deserves everything they get. The end.

    For those who don't see the sound reasoning of that statement, you can get a debit card at your bank. They will happily set you up.

  • Report this Comment On July 02, 2010, at 4:21 PM, infopackrat wrote:

    Taking plastic is more than interchange fees. The theater I part-time at was considering accepting credit cards--until my boss talked to a friend of his who ended up raising his menu prices 6% across the board--subscription fees, additional accounting expenses

  • Report this Comment On July 02, 2010, at 6:14 PM, daleinaz wrote:

    @Graybear1951, merchants are not permitted (by contract with MC/V) to offer cash discounts or add fees for card use. Besides, merchants know that you spend, on average, 25% more when you use a card.

    Still, there are costs associated with cash handling as well (security, making change, etc.) which cards reduce.

    @pkluck, you are absolutely correct!

  • Report this Comment On July 03, 2010, at 6:17 PM, Airdriver100 wrote:

    AnotherNavyFool is in the same boat as I.

    I get a lotta rebate money because we ALWAYS pay our bills on time.

    After awhile, USAA will stop rebates as there will be insufficient merchant fee payments to fund rebates.

    I lose. Congress preens. It stinks.

  • Report this Comment On July 07, 2010, at 3:41 PM, canrightc wrote:

    I second the previous Comment.... USE A CREDIT UNION! I have been a member for 20+ years. great service, full services and low fees.

  • Report this Comment On July 07, 2010, at 10:21 PM, Charnar wrote:

    To AnotherNavyFool-

    I think the anti-gov't sentiment, fashionable though it may be these days, is misguided.

    Don't forget that this is just a zero sum game. The banks get the $$ from the merchants, and the merchants price it into their products to get it from you. That "rebate" you get comes from somewhere-- you!

    If merchants make more $$ (and don't give it back to consumers by lowering prices-- which they may or may not depending on how competitive their industry is), then they give it back in other ways like expanding their operations or product selection, hiring more workers (we're all for that these days, right?), innovating, upgrading technology, improving services, etc. Merchants do these things when they make more money. Banks don't.

    I am a merchant (and a consumer, of course) and I can tell you society is waaaay better off if you're giving your money to me directly than if we have a middleman bank skim a piece before giving you back your precious "rebate". When I make more money, I provide you a better service directly, and more responsively, tangibly improving you and your community's daily lives.

    These "rebates" are a shell game designed to get you to use the card more often, giving the banks huge profits by the power of multiples, at the expense of merchants. Who do you think foots the bill for all those airline miles? Citibank? Delta? No, it's me, and ultimately you.

    Consumers can switch to a credit union if they want to (I wholeheartedly encourage it-- looks like you already do, so kudos to you), but we merchants can't escape the banks and their fees; there's no competition, no alternative for us.

    And if you think thieves used to make more money by mugging housewives of their grocery cash than by stealing their identities, think again.

    We're not getting reamed in any new ways here, with KY or without. What we will be getting is a disclosure on our statement that finally explains why our butt has been hurting for so long. Cold comfort, maybe, but I still call that an improvement.

  • Report this Comment On July 08, 2010, at 12:32 AM, Shaw211 wrote:

    Charnar wrote "I think the anti-gov't sentiment, fashionable though it may be these days, is misguided."

    Seen this year's deficit? And next year's? Considering that, I don't think the anti-gov't sentiment is misguided at all.

  • Report this Comment On July 13, 2010, at 8:18 PM, Gorm wrote:

    NBD Bank was first to push debit cards back in 1988 when there was NO market, ie less than 1%. While certainly a source of income, it was a convenience designed to replace expensive to process paper checks.

    Back then we enticed the merchant to the debit card benefits, ie a small fixed fee, ie $.20, certainty of payment, quicker funds availability, benefit of enabling customers to withdrawal cash meaning there was less cash to count, control, deposit. It was a win, win all the way around. The merchant had to install a rented terminal. Transactions were batched separately and deposited daily. While the transaction went thru the same MC switch debit card trans were pinned and priced differently than credit card transactions that typically bear a fee plus interchange fee of 1 to 3%.

    Then some banks started getting greedy. Can remember that Fifth Third realized they could collect MORE in interchange fees if processed as a credit card so they charged consumers $.50 if the customer pinned their debit card transactions. What is ironic now is on the business side of the bank it is selling the merits of debit card in addition to credit card while the retail side of the bank is offering incentives or assessing penalties on consumers who don't maximize bank income for them.

    It was a very good idea that just got manipulated for personal gain.

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