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Visa (NYSE: V ) and MasterCard (NYSE: MA ) plunged more than 10% last week, after the Federal Reserve proposed limiting debit-card interchange fees to between $0.07 and $0.12 per transaction -- more than 80% below what's currently charged.
There are a few misconceptions about how these new rules would work, and especially what they'll accomplish.
Judging by the drop, you'd think the rules directly affect Visa and MasterCard. In truth, they don't -- although both companies could be indirectly hurt in a big way.
Interchange fees -- the small amounts charged to merchants each time you swipe a card -- are calculated and collected by Visa and MasterCard. But the money is remitted back to the bank that issued the card; Bank of America (NYSE: BAC ) and JPMorgan Chase (NYSE: JPM ) are the largest. These interchange fees are how banks make money on debit cards. (And you thought they were giving you something for free!) Visa and MasterCard make money on additional, smaller fees that are separate from interchange and not affected by the Fed's proposals. The reason bank stocks didn't plunge along with Visa and MasterCard is because they're large and diversified. While lucrative, interchange isn't a make-or-break profit center for large banks.
So if the banks will suffer directly from the new rules, why did Visa and MasterCard fall so hard? Visa actually explains why in its annual report (emphasis mine):
If we cannot successfully defend our ability to set default interchange rates to maximize system volume, our payments system may become unattractive to issuers and/or acquirers. This could reduce the number of financial institutions willing to participate in our open-loop multi-party payments system, lower overall transaction volumes and/or make closed-loop payments systems or other forms of payment more attractive. Issuers could also begin to charge higher fees to consumers, thereby making our card programs less desirable and reducing our transaction volumes and profitability. Acquirers could elect to charge higher merchant discount rates to merchants, regardless of the level of Visa interchange, leading merchants not to accept cards for payment or to steer Visa cardholders to alternate payment systems. In addition, issuers or acquirers could attempt to decrease the expense of their card programs by seeking incentives from us or a reduction in the fees that we charge.
Visa and MasterCard suffer when interchange drops because it makes debit less lucrative for banks; thus, those banks stop pushing debit cards onto their customers. And since debit has been the main growth driver for Visa and MasterCard, this is a big deal. They definitely lose from these rules.
But who wins? That's hard to say.
The Fed's rules are meant to send relief to retailers who say they're often suffocated by interchange fees. Fees had totaled 1%-3% of each purchase, so any profit margin less than that could be wiped out. Some merchants selling low-margin items like newspapers simply stopped selling, because interchange fees not only wiped out profit margins, but ended up turning sales into a loss. The Jacksonville Business Journal tells the story of a 7-Eleven franchise owner: "His profit margin on that newspaper is only 6 cents, but his debit card interchange fee is 12 to 14 cents, meaning he loses money on that transaction."
But it's no sure thing that the proposed rules will in fact help merchants. The merchants significantly hurt by interchange fees are selling commodity-type products (like newspapers) where competition is fierce. In those commodity businesses, any decrease in cost should be passed on to customers via lower prices, or else competition would swoop in with cheaper goods. In that case, you'd think customers would win.
On the other hand, there's no evidence that merchants with pricing power actually pass the savings of lower interchange fees onto customers. Australia, for example, passed similar regulations on interchange fees in 2003, and the Government Accountability Office found that "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." In that case, you'd think merchants win.
But the third factor that neutralizes potential gains to either consumers or merchants is banks. If banks can not longer rake in money from debit interchange, guess what? They're not going to sit idly by and take it. They'll find new revenue sources, such as monthly fees on checking accounts that used to be free, annual fees on credit cards, or higher interest rates on loans. In Australia's case, the same GAO report notes that "costs for card users, such as annual and other fees, have increased."
In the end, I guess I'm skeptical that the new rules will achieve anything except a shuffling of costs. When I read headlines that say the Fed's proposal will bring relief to consumers and small businesses, I can't help but think that's simply not going to be true. Interchange fees might fall, but banking fees will rise.