Research Programs
More
What are you looking for?
Showing 9 of 115 Results in Payments & Payment Networks
ICLE White Paper Executive Summary Capital One’s proposed acquisition of Discover Financial Services has the potential to transform competition and consumer welfare in the retail banking market. Through . . .
Capital One’s proposed acquisition of Discover Financial Services has the potential to transform competition and consumer welfare in the retail banking market. Through synergies and cost savings, the new entity would compete more vigorously with other banks and payment networks. Not only will this better serve the public in general, by bringing together the firms’ traditional expertise in the development of innovative banking and credit card markets aimed at middle-income consumers, it would also likely expand financial inclusion among underserved communities. And while some critics have expressed concerns that the merger could harm competition, those concerns are speculative and ungrounded in well-established principles of antitrust analysis. Major points to consider include that:
On Feb. 18, 2024, Capital One Financial Corp. announced that it had entered into an agreement to acquire Discover Financial Services in an all-stock transaction valued at $35.3 billion.[1] Before the transaction can be finalized, however, it must be approved by both the U.S. Office of Comptroller of the Currency (OCC) and the Federal Reserve. The two agencies held a July 19, 2024, public meeting on the proposed merger, and have extended public comments on the deal until July 24, 2024.[2]
The proposed acquisition has engendered substantial public and political scrutiny from critics who claim it would have anticompetitive effects. For example, a number of Democratic members of Congress,[3] as well as members of the House Financial Services Committee, specifically,[4] and one Republican senator,[5] have written to the regulators responsible for reviewing the merger to urge that it be blocked on that basis.
These criticisms of the proposed merger, however, are confused. To be sure, the combined bank would be larger than either of the two companies standing alone. Yet its size still would pale in comparison to firms such as JPMorgan Chase, Citibank, and other retail bank companies.
More importantly, reflexive “big is bad” arguments overlook the pro-competitive benefits of the merger to consumers and the banking industry. By combining Capital One’s innovative style and marketing dynamism with Discover’s existing network infrastructure and widespread acceptance, the new company could provide a viable new competitor to both existing large banks and to the payment-card-network space currently dominated by Visa and MasterCard. The result should be enhanced competition across the board, but particularly in the market for payment card networks, about which many of these same critics of this merger have complained lacks adequate competition due to the supposed Visa and MasterCard “duopoly.” Rather than trying to artificially impose a counterproductive scheme of competition on that market through heavy-handed government regulation, such as the Credit Card Competition Act,[6] the merger would do exactly what sponsors of that act claim to desire: foster more robust competition in the payment-card-network space.
This white paper uses the tools of law & economics to evaluate the likely effects of the merger, with a particular focus on two of the key criteria the agencies are required to evaluate: (1) the convenience and needs of the communities to be served by the combined organization and (2) competition in the relevant markets.[7]
The primary communities served by both Capital One and Discover comprise lower-risk low-income and middle-income consumers who have been underserved by other large financial firms. The merged company will presumably continue to seek to attract and maintain such consumers, while also potentially expanding into other market segments. Indeed, the new company may better serve such communities. This could be achieved through synergies that would enable it to invest in innovation and thereby offer better products at a lower cost. In addition, the combined firm plans to issue debit cards on its own proprietary network, enabling it to offer enhanced products to consumers (because it will not be subject to the price controls and routing requirements imposed on debit card issuers subject to the Durbin amendment and related regulations). For example, the company should be better able to market no-fee, no-minimum-balance bank accounts to underserved low- and middle-income consumers. Furthermore, by combining some credit card operations, the new entity should benefit from scale economies and the ability to cross-market products.
On the competition side, the relevant markets are, broadly, banking (deposits and loans) and payments (card issuance and acceptance, and network facilitation). With respect to the former, the combined company would be the sixth-largest bank in the United States by assets, and roughly one-quarter the size of JPMorgan Chase (the nation’s largest bank).[8]If the relevant market is large banks with national reach, the merger will plausibly result in an increase in competition, as the new entity will have greater scope and scale, enabling it to compete more effectively with other large national banks.
Regarding credit card issuance: recent figures suggest that Capital One and Discover combined would be the largest holder of credit card debt in the nation, accounting for nearly 22% of outstanding credit card loans by dollar amount.[9]Even so, and contrary to claims made by some critics of the proposed merger,[10] there is no reason to believe this would harm competition. The increase in market share for credit card debt would not trigger thresholds inviting close scrutiny under federal bank-merger guidelines, or the 2023 Federal Trade Commission (FTC) and U.S. Justice Department (DOJ) merger guidelines.[11] Moreover, as the company notes in its filing with the regulators:
Vertically integrating with Discover’s payments networks will add scale to these credit and debit networks—which respective market shares are in long-term decline— making the networks less costly to operate on a marginal basis and more attractive to consumers and merchants. The combination will also allow Capital One to lower its transaction-related costs and to reinvest those dollars in improved banking products and services, including investments into the payments networks to reduce fraud, improve dispute resolution processes, and lessen information sharing friction to the benefit of consumers and merchants. These network investments will allow Capital One to further scale the networks, improve the actual and perceived acceptance of the networks, and create a credible alternative to the Visa, Mastercard, and Amex payments networks, which dominate the industry today.[12]
Critics of the merger, by contrast, have failed to articulate any tangible harms to competition or consumers from the merger beyond reflexive “big is bad” rhetoric.
From a law & economics perspective, the merger’s potential to create a stronger fourth network aligns with the theory that increased competition can lead to greater market efficiency and consumer welfare. A more competitive network landscape could pressure all players to improve their offerings, potentially resulting in lower fees, better security features, and more innovative payment solutions. This outcome would be consistent with the goals of antitrust law, which seeks to promote competition, rather than protect individual competitors.
In sum, the evidence strongly suggests that this merger would meet the needs and convenience of the communities served by the combined organization and would be pro-competitive in all relevant markets.
The prospective acquisition of Discover by Capital One would bring together Capital One’s savvy marketing and innovation advantages with Discover’s legacy advantage as a payment-card processing network, thereby creating a new viable competitor to both existing banking giants (such as JPMorgan Chase and Citibank) as well as existing payment networks (Visa, MasterCard, and Amex). At the same time, however, the combined entity will remain a fraction of the size of these incumbent banks and networks. The end result should benefit competition and consumers substantially, especially in the network issuing space.
Discover Financial Services originated in 1985 as a subsidiary of Sears, Roebuck, and Co., arising as a general-purpose spinoff of the legendary Sears credit card program. In 1985, Sears was the largest consumer-lending operation in America, with 60 million cardholders and customer receivables of more than $12 billion.[13] The ubiquity of the Sears credit card owed in large part to the department store’s towering presence in the nation’s retail landscape, and particularly the company’s long-established Sears catalog. Sears had 796 retail stores and more than 3,000 branch offices of its subsidiaries: Dean Witter Financial Services, Allstate Insurance, Coldwell Banker real estate, and Sears Saving Bank.[14] The launch of the general-purpose Discover credit card was part of a larger push at the time by Sears into the consumer retail financial services space, including bank accounts, ATMs, and low-cost retirement brokerage accounts offered by Sears’ Dean Witter Reynolds Inc. brokerage subsidiary.[15] The card was issued through Greenwood Trust Co. bank, which was owned by Sears. Sears was able to capitalize on its relationship with those millions of established Sears credit card customers to launch a new general-purpose card to rival Visa and Mastercard.
The Discover Card’s launch illustrates the logic of two-sided payment card markets and the need to attract both consumers and merchants to the platform.[16] Because of Sears’s existing relationships with 60 million cardholders, Discover likewise found it relatively easy to attract cardholders. The company, however, faced greater difficulty in persuading merchants to take up the card, in part because merchants were reluctant to accept a card affiliated with a major retailing rival (a difficulty further compounded by the fact that the original card face featured an image of the Sears Tower). To induce merchant acceptance, Discover offered a lower merchant discount rate than Visa and MasterCard-branded cards.[17] Today, Discover’s average merchant discount rate remains below that of Visa, MasterCard, and American Express.[18]
To encourage consumers to use the card, Discover’s initial strategy was to differentiate itself by offering a card with no annual fee and a cashback-rewards program for purchases (including quarterly “bonus categories”), both of which were novel and innovative concepts at the time. This helped to attract consumers and carve out a niche in the competitive credit card market.[19] Because of Sears’ massive network of retail stores and affiliates, Discover didn’t need to establish a separate system of bank branches to service customers, a distinctive characteristic that remains the case today (although, today, it is all online). The card was introduced with a 1986 Super Bowl commercial.[20]
One of Discover’s key innovations was its approach to the payment network. Like American Express and Diners Club (at the time), but unlike most other issuers, Discover chose to operate a vertically integrated, “three-party” model, acting as card issuer, acquirer, and payment network.[21] This structure enabled Discover to offer merchants lower fees relative to other acquirers, which helped in building acceptance so that it could compete more effectively with “four-party” cards issued on the Visa and Mastercard networks.[22]
In 1993, Sears spun off Dean Witter into a new company and Discover became part of Dean Witter. In 1997, Dean Witter merged with Morgan Stanley and later rebranded itself as Discover Financial Services Inc. In 2007, Discover Financial Services became an independent company. In 2004, Diners Club (then owned by Citigroup) signed an agreement with Mastercard to provide acceptance in the United States and Canada, making it a four-party card issuer in these markets—and leaving Discover and American Express as the only three-party issuers in the United States.[23] In 2008, Discover purchased Diners Club International from Citigroup, giving it an international payment network, albeit one that today has only a tiny share of transactions. (The U.S. and Canadian franchises of Diners Club were not included in the deal, and were sold by Citigroup the following year to BMO International.)[24]
Consistent with its original plan to evolve into a full-service retail banking establishment, in the late 1990s and early 2000s, Discover expanded its product line beyond credit cards. It ventured into personal loans, student loans, and savings accounts, leveraging its brand recognition and customer relationships to compete in broader financial services. In 2005, Discover acquired the Pulse electronic funds transfer (EFT) network, which provides single-message (PIN) ATM and debit payments for around 4,500 smaller banks.[25]
Despite its early distinction as a market innovator, over time, Discover has grown somewhat stagnant. In terms of credit card market share by purchase volume, Discover has been stuck at approximately 4% to 5% of the U.S. market for almost 20 years and has a negligible global presence.[26] While Discover has a slightly larger number of credit cards in circulation than American Express, Amex’s market share by purchase volume is roughly five times that of Discover.[27] As a network competitor, therefore, Discover has neither the large cardholder base of Visa and MasterCard nor Amex’s highly coveted high-spend customer base. As one news report summarized Capital One’s arguments in support of the deal, “Discover’s network has ceded market share over the past decade and Capital One, as a much bigger bank, can provide the additional scale and volume Discover needs to be competitive.”[28]
Capital One Financial Corp. emerged in the early 1990s as a spin-off from Signet Bank, under the leadership of Richard Fairbank and Nigel Morris.[29] Their vision was to revolutionize the credit card industry by applying data analytics and information technology to consumer finance.[30] This approach, often referred to as “information-based strategy,” allowed Capital One to tailor its offerings to specific customer segments, a novel concept at the time.[31]
The company’s key innovation was its use of data-mining techniques to identify and target potential customers with personalized credit card offers.[32] This strategy allowed Capital One to extend credit to a broader range of consumers, including those who might have been overlooked or rejected by traditional banks.[33] By using sophisticated risk-assessment models, they could offer competitive rates to customers across various credit profiles, effectively disrupting the one-size-fits-all approach prevalent in the industry.[34] Writing in the Financial Times, former Federal Deposit Insurance Corp. (FDIC) Chair Sheila Bair noted:
I suspect Capital One’s subprime market share is relatively substantial because other banks simply have less (or no) interest in serving subprime customers. Subprime lending involves higher capital requirements, greater regulatory scrutiny and more resources to underwrite and manage those accounts. Any concentrations in the subprime market are the result of banks’ conscious investment decisions, not barriers to entry.[35]
Capital One’s market entry coincided with the rise of direct marketing in the financial sector.[36] The company leveraged this trend by aggressively promoting its products through direct-mail offers, a strategy that helped it rapidly acquire customers and market share.[37] This direct-to-consumer approach bypassed traditional banking channels and allowed Capital One to build a national presence without the need for an extensive branch network.[38]
As the company grew, it continued to innovate in product design and customer acquisition. Capital One introduced features like balance transfers with low introductory rates, cashback rewards, and no annual fee cards, which were not common at the time.[39] The company was also one of the first banks to offer a secured credit card.[40] These offerings appealed to consumers and forced competitors to adapt, ultimately benefiting the broader market through increased competition and more favorable terms for cardholders.
Capital One’s disruptive influence extends beyond credit cards. The company has expanded into retail banking, auto financing, and savings products, often bringing its data-driven approach to these sectors.[41] For instance, its online savings accounts offer higher interest rates than many traditional banks, challenging the status quo and prompting other institutions to improve their offerings to remain competitive.[42]
Capitol One’s acquisition of Discover will have manifest benefits to consumers, competition, and innovation in the payment-card market. By combining the advantages of Discover’s existing (but somewhat stagnant) presence in the payment-card-network space and its reach into middle-class consumers with Capital One’s innovative culture in payments and data security and its marketing savvy, the deal offers the potential to create a viable competitor to existing mega-banks and the dominant card-processing networks. As noted, the proposed deal has elicited some criticism from politicians, but none of those criticisms have amounted to much more than a reflexive “big is bad” mentality and vague, unspecified concerns about the potential for harm to competition and consumers. By contrast, the potential benefits of the deal are manifest and concrete.
These benefits are explained in greater detail below, but in broad terms comprise the following two components:
This section analyses the various components of the proposed acquisition. From an industrial-organization perspective, this has both “horizontal” and “vertical” components. Both companies accept deposits, issue loans, offer credit and debit cards, and offer other financial services; the combination of these business lines would therefore be considered a horizontal merger. While such mergers have the potential to be anticompetitive, they can also be pro-competitive, as demonstrated by many horizontal “four-to-three” mergers in the wireless industry discussed in the first sub-section below.
While these horizontal aspects are tasty hors d’oeuvres, the main course in Capital One’s acquisition of Discover is its purchase of Discover’s payment networks, which would facilitate vertical integration with many of Capital One’s existing products (including all of its debit cards).[44] The beneficial effects of this vertical aspect of the merger are addressed in the separate subsections on credit cards, debit cards, and banking. This is followed by a more detailed discussion of the effects of the merger on the identification and deterrence of fraud—and the benefits this would bring to consumers and merchants. The final subsection addresses some concerns raised by critics of the merger.
Some lessons may be learned from mergers in other industries where two mid-size firms merge to create a competitor that is similar in size to the market leaders. An example is so-called “four-to-three” mergers in wireless telecommunications. A survey of empirical research on these mergers, undertaken by a team that included two of the authors of this white paper, provides insights that may help to evaluate the merger between Capital One and Discover.[45]
First, the paper notes the importance of considering both price and nonprice effects when assessing mergers. In the case of Capital One and Discover, while price effects (such as interest rates or fees) are crucial, nonprice factors like investments in technology, product innovation, and service-quality improvements should be given substantial weight.[46] The merger will enable the combined entity to increase investments in digital-banking capabilities, artificial intelligence, and data analytics—all areas where both companies have shown strengths. This increased investment capacity could lead to more innovative financial products and improved customer experiences, ultimately benefiting consumers.
Second, the review of empirical research highlights that mergers can lead to more symmetrical market structures (that is, with firms of more equal size), which may result in stronger incentives for individual firms to invest and compete.[47] In the context of the credit card and banking industries, a merged Capital One-Discover entity could become a more formidable competitor to larger players like JPMorgan Chase, Bank of America, and Citigroup. This increased symmetry in market power could drive all players to innovate and compete more aggressively, potentially leading to better offerings for consumers across the industry.
Lastly, the empirical research suggests that the optimal number of competitors in a market depends on various factors, including geographic and demographic considerations.[48] In the U.S. financial-services market, which is both large and geographically diverse, the merger could potentially create a stronger nationwide competitor. By combining Capital One’s extensive customer base and marketing prowess with Discover’s payment network and reputation for customer service, the merged entity could more effectively compete across different regions and customer segments. This could be particularly beneficial in making Discover a more effective competitor, as it would gain access to Capital One’s larger customer base and potentially expand the reach and utilization of its payment network.
Three networks currently account for approximately 96% of credit card purchase volume in the United States: Visa (52%), Mastercard (25%), and American Express (20%).[49] Discover has most of the remaining 4%, a proportion that has declined from 6% in 2011.[50] Capital One’s acquisition of Discover could potentially create a more robust fourth network, aligning with some legislators’ stated desire for an increase in the number of competitors in this market.[51]Unlike current proposed legislative interventions, however, it also would more plausibly lead to a genuine increase in competition, as Capital One would have strong incentives to identify ways to reinvigorate the network. Unlike some legislative proposals ostensibly intended to promote competition, but which likely would lead to increased fraud, the merger would likely improve the detection and prevention of fraud.
Capital One’s extensive cardholder base and innovative approach to payments could provide the scale and technological edge that Discover’s network has been lacking. Capital One’s data analytics capabilities and marketing prowess could be leveraged to expand the network’s reach, potentially making it more attractive to both merchants and consumers. This, in turn, could lead to a more competitive market in which four major players compete, potentially driving down transaction fees and spurring further innovation in payment technologies.
Moreover, whereas mandatory routing regulations—such as those contained in the Durbin amendment and the proposed Credit Card Competition Act—lead to data fragmentation that would undermine fraud detection, the combination of Capital One’s innovative data analytics with Discover’s networks would likely improve fraud detection. For example, Capital One recently partnered with Stripe and Ayden to build an open-source application programming interface (API) that enables any entity in the payment stack to share real-time transaction data, enabling Capital One to better detect fraud.[52]
The transaction also potentially offers an opportunity for Capital One to shift the debit cards of its current and future bank customers over to Discover’s payment networks. Capital One founder and CEO Richard Fairbank has stated that the company intends to transfer all its debit cards to the newly acquired networks.[53]
By moving customers onto Discover’s three-party payment card network, Capital One’s customers will be able to avoid the distortions imposed by the Durbin Amendment’s price controls. In turn, this will enable Capital One to offer rewards and maintain free checking accounts for lower-income consumers. These price controls only apply to debit cards issued on four-party payment networks, so Capital One will be able to avoid them by issuing debit cards on its own newly acquired three-party network.
Under a provision of the Dodd-Frank Wall Street Reform Act of 2010 known commonly as the “Durbin amendment,” the U.S. Federal Reserve imposed caps on debit card interchange fees for banks with more than $10 billion in assets (“covered banks”), as well as routing requirements for all debit card issuers.[54] As a result, debit card interchange fees fell by about 50% for large banks almost immediately. Interchange fees on debit cards issued by smaller banks and credit unions initially fell by a smaller amount, and interchange fees on single-message (PIN) debit cards have now fallen to similar levels as PIN debit cards issued by larger banks.[55]
Estimates suggest that the Durbin amendment initially reduced annual interchange fee revenue for covered banks by between $4.1 and $8 billion.54F[56] In response, covered banks eliminated or reduced card-rewards programs on debit cards.62F[57] They also typically raised monthly account maintenance fees and increased the minimum balance needed for a fee-free account.[58] These changes have resulted in an increase in unbanked and underbanked households in the United States, particularly among lower-income consumers.[59]
As a covered bank, Capital One might have been expected to have been among those that reduced the availability of free checking. But Capital One’s business model is focused on attracting the very clients who would be put off by having to pay a fee for their checking account. So, as noted above, it has kept fee-free checking accounts with zero minimum balances.[60] It has been able to do this, in part, because of its lower costs as a primarily online bank. As with most covered banks, however, Capital One discontinued its debit card rewards program following the implementation of the Durbin amendment.[61]
Capital One’s debit cards currently operate on four-party networks. By contrast, the Discover card network operates as a three-party closed-loop system, in which the issuer and the acquirer are the same and there is, therefore, no interchange fee. As such, debit cards issued directly by Discover are not subject to the Durbin amendment, which is why it is able to continue to offer cashback rewards of 1% on purchases made on those cards.[62] Shifting all of Capital One’s debit cards over to the Discover network (including, in particular, the PULSE single-message PIN-debit network) would allow Capital One to more effectively balance the two sides of the market, using fees charged to merchants to cross-subsidize holders of Capital One current accounts. This might include:
Another potentially significant benefit of the merger is its effect on fraud, which is a challenge for every party in the payments ecosystem: issuers, acquirers, merchants, and cardholders. Global losses from payment-card fraud were estimated to be $34 billion in 2022, of which 36% was attributed to the United States.[63] Discover, in particular, has had various data security breaches and other compliance issues.[64] By combining Capital One’s innovative approach to data management with Discover’s payment networks, the combined entity could help to significantly reduce such fraud.
Issuers and networks have developed increasingly sophisticated systems to reduce fraud. For example, when a card with a chip is dipped or tapped, it transfers a unique one-time token, generated by the chip, that is encrypted and can only be read by the issuer.[65] The implementation of chip-based tokenized transactions has dramatically reduced fraud compared to the simpler magnetic stripe cards. Mobile payments also use tokens in a similar way.
But tokens by themselves can’t solve the problem of stolen cards and hacked online accounts. Issuers and networks have thus implemented other measures, most notably systems of multifactor authentication. An example is 3D-Secure (3DS), which involves using the information sent in the first (authorization) message to check against a cardholder’s profile. If the proposed payment fits the profile, it is permitted; if not, then the cardholder is asked to complete two-factor authentication on the transaction.[66]
3DS would not be possible without cardholder profiles, which are an example of the application of AI to payments. Since the 1990s, Visa and Mastercard have used machine learning to develop cardholders profiles, which then enable them to identify potential instances of fraud.
Payment networks, issuers, and other companies in the card-processing stack have also begun to use biometrics, typically combined with machine learning, as part of the authentication and authorization process.[67] Capital One has been a leading innovator in such methods, going back at least to its pattern-tracing system for accessing mobile accounts.[68] From 2018 to 2020, Capital One applied for 23 biometric-related patents, including one for voice recognition.[69]
One problem that can reduce the effectiveness of AI-based fraud detection (including 3DS) is data fragmentation. When a consumer has cards from multiple issuers on multiple networks, or where the same card is run by different merchants over different networks (which is currently possible with debit cards, due to the Durbin amendment’s routing requirements), it may be difficult for networks and issuers to build a consistent picture of an individual’s payment patterns. This makes it more difficult to identify attempted payments that do not fit a pattern.
The merger might improve fraud detection in several ways. First, when Capital One’s debit cards are moved to Discover’s networks, they will no longer be subject to the Durbin amendment’s routing requirements, and thus all transactions on those cards will be monitored directly by Capital One’s systems. Second, Capital One will be able to implement its highly innovative fraud-detection and prevention systems across all Discover networks. Third, as noted above, Capital One recently partnered with Stripe and Ayden to build an open-source API that enables any entity in the payment stack to share real-time transaction data,[70] which should help Capital One to address fraud more effectively and in a manner comparable to existing larger networks (Visa, Mastercard, American Express) despite of its smaller size.
These improvements in fraud detection and prevention would have both direct and indirect benefits for merchants and consumers. The direct benefits arise from the simple fact of experiencing fewer fraudulent transactions. For consumers, this means not having to identify fraudulent transactions or go through the process of initiating chargebacks. For merchants, it means fewer chargebacks and related disputes with issuers. The indirect benefit is lower costs all around, which can be passed on in the form of lower fees and/or additional account or card benefits. And these increased benefits should be expected to drive an increase in the use of Capital One cards, thereby generating a virtuous cycle of network effects, whereby fraud can be reduced further, while use and acceptance of the cards are further increased.
Critics of the merger have identified ways the proposed merger could harm banking consumers by increasing the cost of credit, increasing fees, and reducing the interest paid to depositors.[71] There is, however, little evidence the merger poses potential antitrust harm to depositors. Of note:
Capital One and Discover have both been industry leaders in increasing financial access for underserved consumers. For example, most bank accounts in the United States today impose monthly maintenance fees, especially for lower-income consumers who cannot meet the stiffer average balance requirements required to be eligible for free checking. Both Capital One’s 360 Checking Account and Discover’s Cashback Debit accounts offer free checking accounts with no minimum balance requirements. Capital One was also one of the first large banks to eliminate overdraft fees.
With such small market shares, it would be a stretch to conclude that a merger between Capital One and Discover would have any noticeable effect on competition for deposits or depositors in the U.S. banking sector. Moreover, as primarily online banks, Capital One and Discover compete nationally against other online banks, as well as “traditional” banks with substantial online presence. Thus, even if the merged firm were to try to charge above-competitive fees or offer below-competitive interest rates to depositors, such efforts would be likely to fail in the face of competition from hundreds of other competing banks and credit unions.
Based on the above analysis, the prospective acquisition of Discover by Capital One augurs well for consumer welfare. As noted, however, some critics have raised concerns regarding certain aspects of the merger. Here, we briefly review these concerns.
The merged firm would be the largest holder of credit card debt, accounting for nearly 22% of outstanding credit card loans by dollar amount.[75] That, in and of itself, is not necessarily a concern; as Capital One points out in its filing, it would not exceed any threshold in a conventional antitrust analysis.[76]
Much of the concern has been focused on potential harms to specific groups of credit card customers, especially the “near-prime” or “subprime” segments of borrowers with FICO scores below 660.[77] A key question for antitrust analysis is whether these constitute a distinct relevant market. One critic of the merger argues that these consumers’ higher risk, as well as Capital One and Discover’s direct-mail marketing to these consumers, suggest they constitute a distinct “submarket.”[78] In contrast, the Bank Policy Institute reports:
No evidence has been put forth by critics of the proposed merger to define the boundaries of the subprime segment and establish that consumers in this segment are sufficiently isolated for it to be considered a distinct submarket for antitrust purposes.[79]
One important consideration in evaluating this concern is that a consumer’s credit status is rarely static over time. Due to changes in income and other circumstances, a subprime borrower today may be a prime borrower next year, and vice versa. Using data from 2014 and 2015, Fair Isaac found that a “notable percentage” of FICO scores migrated up or down more than 20 points in a six-month period, with 14% of accounts decreasing by more than 20 points, and 19% increasing by more than 20 points.[80] Thus, even if a subprime or near-prime market segment can be defined, migration into and out of these segments makes it exceedingly difficult to establish a reliable market definition for antitrust analysis.
Among consumers with at least one credit card, as of 2023, 8.6% were near-prime and 4.4% subprime.[81] The Bank Policy Institute estimates the merged firm would account for a little less than 30% of subprime credit card balances in the United States.[82] Thus, the authors conclude, “If the subprime consumer segment of the credit card market merits separate scrutiny, our analysis indicates that the segment is highly competitive and would remain so even after the proposed merger.”[83]
It is also worth noting that Capital One gained its market share in “subprime” over time through its data-driven strategy. This has enabled the company to identify lower-risk individuals in (otherwise) higher-risk groups, thereby serving otherwise underserved consumers, while limiting default risk.[84] It also provides opportunities for these consumers to migrate toward a lower-risk category by gradually increasing the size of their credit lines as they demonstrate creditworthiness.[85]
Another important aspect of this strategy was the pioneering of two now-widespread credit card offerings: secured credit cards and balance transfers. In 1991, Capital One became the first credit card issuer to introduce a balance-transfer offer.[86] A balance transfer provides a temporarily low interest rate to induce people to move balances from a competing credit card to the card providing the balance-transfer offer. In short, Capital One’s substantial market share in the subprime credit card market is best explained by its innovative culture in meeting the needs of the heterogeneous consumers in this complex market.
Although perhaps not the first to offer a secured credit card, Capital One was arguably the first issuer to implement a major program of such cards.[87] A secured credit card differs from a traditional card in that all or part of the borrower’s credit limit is secured against a cash deposit provided by the consumer at the time of account opening. Secured cards are most useful to consumers seeking to build a credit history or attempting to repair a damaged credit history.[88] Research published by the Philadelphia Fed concludes that a combination of credit-score migration and increased competition has been associated with increasing “graduation rates” over time from secured cards to unsecured cards.[89]
Finally, for credit card issuers, a merger might result in a more effective competitor to the major incumbents, thereby potentially increasing competition, even while reducing the number of competitors. And a smaller number of larger firms facing more intense competition may be better for consumers than a larger number of smaller, less effective firms.
With respect to payment networks, it’s important to note that the proposed merger between Capital One and Discover does not reduce the number of competitors; it merely shifts ownership of Discover’s network to the merged firm, which would presumably adopt Capital One’s more sophisticated technologies, including those related to fraud detection, as discussed above. In this way, it could be argued that Capital One’s acquisition of Discover’s payments network might result in more effective competition to Visa, Mastercard, and American Express, with broad benefits to merchants and consumers.
A major objective of the merger is, as noted above, to switch Capital One’s debit cards over to Discover’s payment network and thereby circumvent the Durbin amendment’s price controls and routing requirements. This vertical integration could allow for more flexibility in fee structures and potentially higher overall revenue per transaction. This would enable Capital One to offer cashback rewards to debit cards and potentially also cross-subsidize accounts in other ways, such as by offering sign-up bonuses.
Consumers would almost certainly benefit from the increased availability of debit card rewards and sign-up bonuses. Cashback rewards may be especially beneficial to lower-income cardholders. Indeed, it is likely that the reintroduction of such rewards will encourage some lower-income consumers, and especially those with poor credit scores and without access to a rewards credit card, to switch to Capital One. Moreover, the prospect of such rewards would likely entice many consumers who are currently unbanked or “underbanked” (i.e., have access to only minimal banking services) to open accounts with Capital One and thereby participate more fully in the banking system.
Of course, if Capital One does charge higher debit card transaction fees than four-party issuers, some merchants may choose to no longer accept its debit cards (and, if Capital One’s terms require merchants to accept all cards operating on its branded three-party network, also its credit cards). And if fewer merchants accept its cards, that will make the cards less attractive to consumers. Capital One will therefore have to balance such potential effects on merchants against the benefits to cardholders, just as Sears did in 1986 when it introduced Discover with lower than prevailing merchant fees in order to incentivize merchant acceptance.
From the perspective of merchants as a whole, the prospect of a larger proportion of consumers having bank accounts, and an even greater proportion paying by card rather than cash, should be attractive, given that card payments can result in increased sales (because consumers are able to spend more than they have in their wallet).[90] Meanwhile, having some consumers use debit cards rather than credit cards should also be attractive. As such, not only does it seem unlikely that many merchants would cease accepting Capital One cards, but it is also unlikely that Capital One switching its debit cards to Discover’s networks would cause net harm to social welfare.
From an antitrust perspective, it appears almost certain that, while some merchants may face higher costs of acceptance, this will be more than balanced by the increase in card-based transactions. Hence, there would be lower net costs for many merchants and an increase in consumer benefits arising from the rewards and other benefits the debit cards would now provide.
A similar issue lay at the heart of the U.S. Supreme Court’s decision in Ohio v. Amex:
Respondent… Amex… operate[s] what economists call a “two-sided platform,” providing services to two different groups (cardholders and merchants) who depend on the platform to intermediate between them. Because the interaction between the two groups is a transaction, credit-card networks are a special type of two-sided platform known as a “transaction” platform. The key feature of transaction platforms is that they cannot make a sale to one side of the platform without simultaneously making a sale to the other. Unlike traditional markets, two-sided platforms exhibit “indirect network effects,” which exist where the value of the platform to one group depends on how many members of another group participate. Two-sided platforms must take these effects into account before making a change in price on either side, or they risk creating a feedback loop of declining demand. Thus, striking the optimal balance of the prices charged on each side of the platform is essential for two-sided platforms to maximize the value of their services and to compete with their rivals.
Visa and MasterCard—two of the major players in the credit-card market—have significant structural advantages over Amex. Amex competes with them by using a different business model, which focuses on cardholder spending rather than cardholder lending. To encourage cardholder spending, Amex provides better rewards than the other credit-card companies. Amex must continually invest in its cardholder rewards program to maintain its cardholders’ loyalty. But to fund those investments, it must charge merchants higher fees than its rivals. Although this business model has stimulated competitive innovations in the credit-card market, it sometimes causes friction with merchants.[91]
Thus, the fact that some merchants may see their costs rise (slightly) as a result of the merger must be weighed against the significant benefits that accrue to consumers and other merchants.
Returning to the criteria by which the Federal Reserve and OCC are required to evaluate this merger, and in service of which this paper has been produced, (1) the convenience and needs of the communities to be served by the combined organization and (2) competition in the relevant markets, the forgoing analysis leads to the following conclusions:
Through these effects, Capital One may attract additional customers, especially those with low incomes or lower credit scores, thereby more effectively meeting the convenience and needs of the communities it serves. At the same time, and for largely the same reasons, it would arguably increase competition in most relevant markets and is unlikely substantially to diminish competition in any markets.
[1] Press Release, Capital One to Acquire Discover, Capital One (Feb. 19, 2024), https://investor.capitalone.com/news-releases/news-release-details/capital-one-acquire-discover.
[2] Press Release, Board of Governors of the Federal Reserve System & Office of the Comptroller of the Currency, Agencies Announce Public Meeting on Proposed Acquisition by Capital One of Discover; Public Comment Period Extended, Federal Reserve Board (May 14, 2024), https://www.federalreserve.gov/newsevents/pressreleases/other20240514a.htm; Press Release, Agencies Announce Public Meeting on Proposed Acquisition by Capital One of Discover; Public Comment Period Extended, Office of the Comptroller of the Currency (May 14, 2024), https://www.occ.gov/news-issuances/news-releases/2024/nr-ia-2024-50.html.
[3] See, Letter to the Honorable Michael Barr, Vice Chair of Supervision for the Board of Governors of the Federal Reserve System and Acting Comptroller Michael Hsu, Office of the Comptroller of the Currency from the Undersigned Members of the Congress of the United States, Office of Sen. Elizabeth Warren (Feb. 25, 2024), available at https://www.warren.senate.gov/imo/media/doc/2024.02.25%20Capital%20One%20Letter1.pdf.
[4] See, Letter to the Honorable Jerome Powell, et. al from the Undersigned Members of the U.S. House of Representatives Committee on Financial Services, House Financial Services Committee Democrats (Feb. 28, 2024), available at https://democrats-financialservices.house.gov/uploadedfiles/02.28_-_ltr_on_ibmr.pdf.
[5] See, Letter to Jonathan Kanter, Assistant Attorney General of the U.S. Department of Justice, Antitrust Division from Senator Josh Hawley, Office of Sen. Josh Hawley (Feb. 21, 2024), available at https://www.hawley.senate.gov/wp-content/uploads/files/2024-02/Hawley-Letter-to-Kanter-re-Capital-One-Discover-Merger.pdf.
[6] See, e.g., Julian Morris & Todd Zywicki, Regulating Routing in Payment Networks (ICLE White Paper 2022-08-17), available at https://laweconcenter.org/wp-content/uploads/2022/08/Regulating-Routing-in-Payment-Networks-final.pdf; Julian Morris, The Credit Card Competition Act’s Potential Effects on Airline Co-Branded Cards, Airlines, and Consumers (ICLE White Paper 2023-11-17), available at https://laweconcenter.org/wp-content/uploads/2023/11/CCCA-Airline-Rewards-Study-v4.pdf.
[7] The list of relevant criteria for consideration includes: the convenience and needs of the communities to be served by the combined organization; each insured depository institution’s performance under the Community Reinvestment Act; competition in the relevant markets; the effects of the proposal on the stability of the U.S. banking or financial system; the financial and managerial resources and future prospects of the companies and banks involved in the proposal; and the effectiveness of the companies and banks in combatting money laundering activities. See Joint Press Release, supra note 4; 12 U.S.C. § 1828(c).
[8] See, Federal Reserve Board, Insured U.S.-Chartered Commercial Banks That Have Consolidated Assets of $300 Million or More, Ranked by Consolidated Assets as of March 31, 2024, Federal Reserve Board (Mar. 31, 2024), https://www.federalreserve.gov/releases/lbr/current.
[9] See, Federal Reserve Bank of New York, Quarterly Report on Household Debt and Credit, 2023:Q4, Federal Reserve Board (Feb. 2024), https://www.newyorkfed.org/medialibrary/interactives/householdcredit/data/pdf/HHDC_2023Q4; 20 Bank Holding Companies With the Largest Credit Card Loan Portfolios, American Banker (Mar. 28, 2024), https://www.americanbanker.com/list/20-bank-holding-companies-with-the-largest-credit-card-loan-portfolios-at-the-end-of-q4.
[10] See Shahid Naeem, Capital One-Discover: A Competition Policy and Regulatory Deep Dive, American Economic Liberties Project (Mar. 2024), available at https://www.economicliberties.us/wp-content/uploads/2024/03/2024-03-20-Capital-One-Discover-Brief-post-design-FINAL.pdf.
[11] See Diana Moss, The Capital One Financial-Discover Financial Services Merger: A Test for the Biden Merger Agenda?, Progressive Policy Institute (Jun. 20, 2024), at 1, available at https://www.progressivepolicy.org/wp-content/uploads/2024/06/PPI-Capitol-One-Discover-Commentary.pdf.
[12] Application to the Board of Governors of the Federal Reserve System for Prior Approval for Capital One Financial Corporation to Acquire Discover Financial Services Pursuant to Section 3 of the Bank Holding Company Act and Section 225.15 of Regulation Y, Federal Reserve Board(Mar. 20, 2024), at 40, available at https://www.federalreserve.gov/foia/files/capital-one-application-20240320.pdf [hereinafter “Capital One Application”].
[13] See, New Sears Credit Card by Year-End, Chicago Tribune (Apr. 25, 1985), https://www.chicagotribune.com/1985/04/25/new-sears-credit-card-by-year-end.
[14] See Nancy Yoshihara, Sears Unveils Its New Credit Card: Multipurpose “Discover” to Get 1st Test Marketing in Fall, Los Angeles Times (Apr. 25, 1985), https://www.latimes.com/archives/la-xpm-1985-04-25-fi-12317-story.html.
[15] Id.
[16] See Todd J. Zywicki, The Economics of Payment Card Interchange Fees and the Limits of Regulation (ICLE Financial Regulatory Program White Paper Series, Jun. 2, 2010), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1624002.
[17] See Chicago Tribune, supra note 13.
[18] See Jack Caporal, Average Credit Card Processing Fees and Costs in 2024, the ascent, https://www.fool.com/the-ascent/research/average-credit-card-processing-fees-costs-america, (last updated Jun. 5, 2024), (noting that “Discover credit card processing fees have the lowest range, excluding outliers.”).
[19] See Eric Schmuckler, Playing Your Cards Right, Forbes (Dec. 28, 1987).
[20] See, Discover—Dawn of Discover, AdAge (Jan. 26, 1986), https://adage.com/videos/discover-dawn-of-discover/1241.
[21] See Frances Denmark, Discover CEO David Nelms Reinvents His Credit Card Firm, Institutional Investor (Dec. 28, 2011), https://www.institutionalinvestor.com/article/2bszspjc02cwjwn5f2pds/portfolio/discover-ceo-david-nelms-reinvents-his-credit-card-firm.
[22] Michael Weinstein, Bankers: DiscoverCard Has Not Hurt Business, American Banker (Mar. 7, 1988).
[23] Diners Club and MasterCard Finalize Alliance, The Payers (Sep. 27, 2004), https://thepaypers.com/payments-general/diners-club-and-mastercard-finalize-alliance–724076.
[24] See, e.g., The Story Behind The Card, Diners Club Int’l, https://www.dinersclubus.com/home/about/dinersclub/story (last accessed Jul. 17, 2024); Press Release, BMO Financial Group Announces Agreement to Acquire the Diners Club North American Franchise From Citigroup, BMO Financial Group (Nov. 24, 2009), https://newsroom.bmo.com/2009-11-24-BMO-Financial-Group-Announces-Agreement-to-Acquire-the-Diners-Club-North-American-Franchise-From-Citigroup.
[25] See Denmark, supra note 21.
[26] See Adam McCann, Market Share by Credit Card Network, WalletHub (May 9, 2024), https://wallethub.com/edu/cc/market-share-by-credit-card-network/25531.
[27] See Fred Ashton, Capital One’s Acquisition of Discover Could Inject Competition Into Payments Market, American Action Forum Insight (Feb. 29, 2024), at fig. 2, https://www.americanactionforum.org/insight/capital-ones-acquisition-of-discover-could-inject-competition-into-payments-market.
[28] Michelle Price, Exclusive: CapOne Tells Regulators Discover Deal will Boost Competition and Stability, Reuters (Mar. 21, 2024), https://www.reuters.com/markets/deals/capone-tells-regulators-discover-deal-will-boost-competition-stability-sources-2024-03-21.
[29] Capital One Financial Corporation, Capturing the Essence of Capital One: 1996 Annual Report 2-3 (1996), available athttps://investor.capitalone.com/static-files/d823fcd3-e1f1-439a-a34f-5296ef58b93c.
[30] See id. at 3, 5-6.
[31] Id. at 3.
[32] See David Morrison & Adrian Slywotzky, Off the Grid, Industry Standard (Oct. 23, 2000).
[33] See Andrew Becker, The Secret History of the Credit Card, Frontline (Nov. 23, 2004), https://www.pbs.org/wgbh/pages/frontline/shows/credit/more/battle.html.
[34] See Morrison & Slywotzky, supra note 32.
[35] Sheila Bair, How the Capital One/Discover Deal Could Boost Competition, Financial Times (May 31, 2024), https://on.ft.com/4640E6h.
[36] See Morrison & Slywotzky, supra note 32.
[37] See Zack Martin, Capital One Makes Big Push to Become a National Brand, Card Marketing (Dec. 2000).
[38] See Jon Prior, Capital One Keeps Closing Branches, Even as Rivals Open Them, American Banker (Jul. 1, 2019), https://www.americanbanker.com/news/capital-one-keeps-closing-branches-even-as-rivals-open-them.
[39] See Lukasz Drozd, Why Credit Cards Played a Surprisingly Big Role in the Great Recession, 6(2) Econ. Insights 10 (Mar. 2021), n. 12, https://fraser.stlouisfed.org/title/6149/item/604454?start_page=ii.
[40] Naomi Snyder, Capital One’s Secret to Success, Bank Director (Aug. 15, 2022), https://www.bankdirector.com/article/capital-ones-secret-to-success (Capital One “invented the secure credit card”); Larry Santucci, The Secured Credit Card Market, Federal Reserve Bank of Philadelphia(Nov. 2016), available at https://www.philadelphiafed.org/-/media/frbp/assets/consumer-finance/discussion-papers/dp16-03.pdf (“While we were unable to identify the first bank to issue a secured card, the innovation is believed to have occurred sometime in the late 1970s.”).
[41] See Alex Woodie, The Modernization of Data Engineering at Capital One, Datanami (Apr. 4, 2022), https://www.datanami.com/2022/04/04/the-modernization-of-data-engineering-at-capital-one.
[42] See, e.g., Sabrina Karl, Best High-Yield Savings Accounts of July 2024—Up to 5.55%, Investopedia, https://www.investopedia.com/best-high-yield-savings-accounts-4770633 (last updated Jul. 17, 2024), (listing Capital One and Discover among the highest-available interest rates for new accounts).
[43] See Anish Kapoor, Capital One-Discover Acquisition: Unpicking [sic] the Consumer and Competitive Benefits, LinkedIn.com (Apr. 15, 2024), available at https://www.linkedin.com/pulse/capital-one-discover-acquisition-unpicking-consumer-benefits-kapoor-53yge.
[44] Capital One itself lists “Combin[ing] Capital One’s scale in credit cards and banking with Discover’s vertically integrated global payments network” and “Enhanc[ing] Capital One’s ability to compete with the national’s largest banks in credit cards and banking” as the top two reasons for its “strategic rationale.” Investor Presentation, Capitol One & Discover (Feb. 20, 2024), at 4 https://investor.capitalone.com/static-files/cfa11729-0aec-43dc-b531-200e250c8413.
[45] See Eric Fruits, Justin (Gus) Hurwitz, Geoffrey A. Manne, Julian Morris, & Alec Stapp, Static and Dynamic Effects of Mergers: A Review of the Empirical Evidence in the Wireless Telecommunications Industry (OECD, DAF/COMP/GF(2019)13, Dec. 6, 2019), available at https://one.oecd.org/document/DAF/COMP/GF(2019)13/en/pdf.
[46] Id. at 17.
[47] Id. at 8.
[48] Id. at 3.
[49] Caitlin Mullin, Capital One Pledges to Give Discover’s Network a Boost, Payments Dive (Mar. 26, 2024), https://www.paymentsdive.com/news/capital-one-discover-acquisition-federal-reserve-occ-debit-credit-card-network-visa-mastercard/711385.
[50] Id.; see also, Leading Credit Card Issuers in the United States from 2007 to 2023, Based on Value of Transactions for Goods and Services,Statista (Feb. 2024), https://www.statista.com/statistics/1080768/leading-credit-card-issuers-usa-by-purchase-volume.
[51] See, e.g., Press Release, Sen. Dick Durbin, Durbin, Marshall Announce Hawley, Reed as New Cosponsors, Growing Support for Credit Card Competition Act, Office of Sen. Dick Durbin (Feb. 14 2024), https://www.durbin.senate.gov/newsroom/press-releases/durbin-marshall-announce-hawley-reed-as-new-cosponsors-growing-support-for-credit-card-comptition-act (arguing that “[f]or too long, the Visa-Mastercard duopoly alongside the Wall Street megabanks have price-gouged hardworking Americans with little-to-no oversight” and “[f]or years, Visa and Mastercard have taken advantage of their duopoly in the credit market to impose extreme fees on small merchants and retailers.”).
[52] Mary Ann Azevedo, When Foes Become Friends: Capital One Partners with Fintech Giants Stripe, Adyen to Prevent Fraud, TechCrunch (Jun. 5, 2024), https://techcrunch.com/2024/06/05/when-foes-become-friends-capital-one-partners-with-fintech-giants-stripe-adyen-to-prevent-fraud.
[53] Transcript of Conference Call Held by Capital One Financial Corporation and Discover Financial Services on February 20, 2024, Filed by Capital One Financial Corporation (Commission File No.: 001-13300), available at https://investor.capitalone.com/static-files/d7b64c07-9663-4b0a-b382-48792a04c148:
“So, on the debit side with the Discover Global Network, with the Pulse PIN debit network, along with their Discover signature debit network, it’s really well-positioned and in a strong position to just basically take our debit volume at this place and at this point, and we feel comfortable moving our entire business over there.” See also, supra note 49 (“Currently, Capital One’s debit cards run on Mastercard’s network, and all of that volume will move to Discover’s network, Capital One executives said Tuesday. Some portion of Capital One’s credit cards will move to Discover’s payment rails as well, Fairbank said. Capital One issues cards on both the Visa and Mastercard networks, with about 42% of the bank’s credit cards running on Visa and 58% on Mastercard, as of 2022, according to Bank of America Securities analysts.”.
[54] H.R.4173 – Dodd-Frank Wall Street Reform and Consumer Protection Act, s.1075(a)(3); Debit Card Interchange Fees and Routing; Final Rule, 76 Fed. Reg. 43,393-43,475, (Jul. 20, 2011).
[55] Todd J. Zywicki, Geoffrey A. Manne, & Julian Morris, Unreasonable and Disproportionate: How the Durbin Amendment Harms Poorer Americans and Small Businesses, Int’l Cntr For L. & Econ. (Apr. 25, 2017), available at https://laweconcenter.org/wp-content/uploads/2017/08/icle-durbin_update_2017_final-1.pdf.
[56] See, e.g., Benjamin S. Kay, Mark D. Manuszak, & Cindy M. Vojtech, Competition and Complementarities in Retail Banking: Evidence From Debit Card Interchange Regulation, 34 J. Fin. Intermediation 91, 92 (2018) (estimating losses of interchange income between $4.1-$6.5 billion); Vladimir Mukharlyamov & Natasha Sarin, Price Regulation in Two-Sided Markets: Empirical Evidence From Debit Cards (Dec. 2019), https://ssrn.com/abstract=3328579 (estimating $5.5 billion annual revenue loss to banks from interchange-fee reductions); Bradley G. Hubbard, The Durbin Amendment, Two-Sided Markets, and Wealth Transfers: An Examination of Unintended Consequences Three Years Later, SSRN (May 20, 2013), at 20, https://ssrn.com/abstract=2285105 (estimating annual revenue loss of $6.6 billion to $8 billion from the Durbin amendment).
[57] See Darryl E. Getter, Regulation of Debit Interchange Fees, Congressional Research Service (May 16, 2017), at 8. See also Electronic Payments Coalition, Out of Balance: How the Durbin Amendment Has Failed to Meet Its Promises 7 (Dec. 2018), available at https://www.electronicpaymentscoalition.org/wp-content/uploads/2018/12/EPC.DurbinStudiesPaper.pdf (Eliminating rewards, such as cash-back on purchases, is functionally equivalent to a price increase).
[58] Mark D. Manuszak & Krzysztof Wozniak, The Impact of Price Controls in Two-Sided Markets: Evidence From US Debit Card Interchange Fee Regulation (Bd. of Governors of the Fed. Res. Sys. Fin. & Econ. Discussion Series, Working Paper No. 2017-074, 2017); Mukharlyamov & Sarin, supra note 56.
[59] Mukharlyamov & Sarin, supra note 56.
[60] See Aly J. Yale, Everything You Need to Know About Banking with Capital One, Wall Street Journal (May 28, 2024), https://www.wsj.com/buyside/personal-finance/banking/capital-one-bank-review.
[61] See Blake Ellis, Wells Fargo, Chase, SunTrust cancel debit rewards program, CNN Money (Mar. 28, 2011), https://money.cnn.com/2011/03/25/pf/debit_rewards/index.htm (noting the move by major banks to cancel debit-card rewards in anticipation of the Durbin amendment going into effect); Richard Kerr, Where Have All the Rewards Debit Cards Gone?, The Points Guy (Jun. 24, 2015), https://thepointsguy.com/credit-cards/rewards-debit-cards-gone (describing the “slow death of debit cards that earn points and miles.”).
[62] See, e.g., Earn Cash Back Rewards with No Fees, Discover (2024), https://www.discover.com/online-banking/checking-account.
[63] Kalle Radage, Credit Card Fraud in 2023, Clearly Payments (Aug. 13, 2023), https://www.clearlypayments.com/blog/credit-card-fraud-in-2023.
[64] See, e.g., Discover Financial Jumps 7% After Agreeing with FDIC to Improve Consumer Compliance, Reuters (Oct. 2, 2023), https://www.reuters.com/business/finance/discover-financial-jumps-7-after-agreeing-with-fdic-improve-consumer-compliance-2023-10-02; David Lukic, The Discover Breach, Credit Card Companies Nightmare, ID Strong (Dec. 11, 2023), https://www.idstrong.com/sentinel/discover-breach-credit-card-companies-nightmare.
[65] EMV chips use a form of public-key infrastructure. The token is encrypted using the issuer’s public key and can only be decrypted using the issuer’s private key. After decrypting the token (technically, a cryptogram), the issuer can validate the transaction by checking its authenticity and integrity. If the token is validated successfully, the issuer authorizes the transaction. If the token cannot be validated, the transaction is declined.
[66] See Elint Chu, What Is New with EMV 3DS v.2.3?, EMVCo (Nov. 12, 2021), https://www.emvco.com/knowledge-hub/what-is-new-with-emv-3ds-v2-3.
[67] See, e.g., NuData: It’s Time for Businesses to Replace the Old ‘New Normal’ With a New One, PYMNTS (Jun. 30, 2021), https://www.pymnts.com/news/payments-innovation/2021/nudata-time-businesses-replace-old-new-normal; Chris Burt, Smartmetric CEO Claims Progress Towards American Biometric Payment Card Launch, Biometric Update (Jul. 18, 2022), https://www.biometricupdate.com/202207/smartmetric-ceo-claims-progress-towards-american-biometric-payment-card-launch.
[68] See Jim Bruene, Capital One Launches SureSwipe for Gesutre-Based Mobile Login, Finovate (Nov. 11, 2013), https://finovate.com/capital_ones_gesture-based_mobile_login_sureswipe.
[69] Capital One Patent Looks To Bring Voice Recognition Technology To Mobile Payments, CBInsights (Oct. 13, 2020), https://www.cbinsights.com/research/capital-one-patent-voice-recognition-tech-mobile-payments.
[70] See supra note 52 and accompanying text.
[71] See supra notes 3-5 and accompanying text.
[72] See Federal Reserve Board, supra note 8.
[73] Id.
[74] See Capital One Application, supra note 12, at 39.
[75] See Federal Reserve Board, supra note 8.
[76] See Capital One Application, supra note 12, at 39-40.
[77] CFPB provides the following definitions: superprime (800 or greater), prime plus (720 to 799), prime (660 to 719), near-prime (620 to 659), subprime (580 to 619), and deep subprime (579 or less). Consumer Financial Protection Bureau, The Consumer Credit Card Market 12 (Oct. 2023), available at https://files.consumerfinance.gov/f/documents/cfpb_consumer-credit-card-market-report_2023.pdf.
[78] Naeem, supra note 10, at 17.
[79] Haelim Anderson, Paul Calem, & Benjamin Gross, Is the Subprime Segment of the Credit Card Market Concentrated? Bank Policy Institute(May 31, 2024), https://bpi.com/is-the-subprime-segment-of-the-credit-card-market-concentrated.
[80] See Fair Isaac Corporation, FICO Research: Consumer Credit Score Migration (2018), https://www.fico.com/en/latest-thinking/white-paper/fico-research-consumer-credit-score-migration.
[81] CFPB, supra note 77, at 16—17.
[82] See Anderson, Calem, & Gross, supra note 79, at Panel C.
[83] Id. at Conclusion.
[84] Becker, supra note 33 (“By identifying lower-risk individuals in high-risk groups, Capital One was able to market to reliable consumers other companies wouldn’t touch, says [Chris] Meyer [CEO of Monitor Networks]. In just six years, Capital One became the sixth-largest credit card issuer in the country. “When others were attacking the market with blunt instruments, Capital One used a scalpel,” says Meyer.”).
[85] Snyder, supra note 40 (“Sanjay Sakhrani, an equity analyst and managing director at the investment bank Keefe, Bruyette & Woods, says the bank focuses its efforts on the most profitable risk-adjusted return segments. “I think they’ve done a very effective job [of] underwriting and managing risks inside of the subprime population,” he says. The bank starts by offering those customers low credit lines and graduates them over time as they demonstrate their credit worthiness.”).
[86] See Drozd, supra note 39.
[87] See Snyder, supra note 40.
[88] See, e.g., Ian McGroarty, CFI in Focus: Secured Credit Cards, Federal Reserve Bank of Philadelphia (Sep. 2019), at 1-2, available athttps://www.philadelphiafed.org/-/media/frbp/assets/consumer-finance/articles/secured-credit-cards.pdf.
[89] Id. at 6-7.
[90] Sumit Agarwal, Wenlan Qian, Yuan Ren, Hsin-Tien Tsai, and Bernard Yeung, Mobile Wallet and Entrepreneurial Growth, AEA Papers and Proceedings, 109:48–53 (2019); David Bounie and Youssouf Camara, Card-Sales Response to Merchant Contactless Payment Acceptance, Journal of Banking & Finance, Vol. 119, issue C. (2020).
[91] Ohio v. American Express Co., 138, S.Ct. 2274, 2276-77, 585 U.S. 529 (2018).
Popular Media Competition benefits consumers, not just through lower prices and better quality, but also by protecting them against fraudulent practices. Clear-eyed government regulation can promote competition . . .
Competition benefits consumers, not just through lower prices and better quality, but also by protecting them against fraudulent practices. Clear-eyed government regulation can promote competition and consumer protection by stomping out fraudulent and deceptive practices as well as facilitating the flow of accurate, easy-to-understand information. But what happens when the government is the source of bad information and uses that to promote specious claims that competition has “failed”? In the case of the Consumer Financial Protection Bureau, another round of misleading economic analysis is being used to justify further intrusions on market competition that could confuse consumers and lead to worse regulation.
Read the full piece here.
ICLE Issue Brief Executive Summary Payment networks connect buyers with sellers. Success hinges on attracting sufficient participation on both sides of the market. Card issuers offer rewards, insurance, . . .
Payment networks connect buyers with sellers. Success hinges on attracting sufficient participation on both sides of the market. Card issuers offer rewards, insurance, fraud prevention, and other benefits that create incentives for use. Issuers can do so, in part, because they receive an “interchange” fee from acquiring banks, who in turn charge a fee to merchants (the “merchant discount rate” or MDR).
Price controls on these fees interfere with the delicate balance of the two-sided market ecosystem. Interchange-fee caps in various jurisdictions have led banks to increase other fees (such as monthly account fees and annual card fees), reduce card benefits, and adjust product offerings. As a result, consumers—especially those with lower incomes—face higher costs and reduced access to financial services. These costs generally exceed by a wide margin any consumer savings from reduced prices. Price controls on MDR, seen recently in India and Costa Rica, have also distorted the market by impeding competition and favoring larger players (big-box merchants and internet-platform-service providers, which are able to monetize in other ways), while harming smaller entities and traditional banks.
Instead of imposing price controls, governments should reduce regulatory barriers and provide core public goods, such as courts of law and identity registers, which enable competition, market-driven innovation, and financial inclusion.
Payment networks are integral to modern economies, facilitating the seamless exchange of goods and services across vast distances and among unfamiliar parties. This issue brief considers the effects of regulatory interventions on such networks, looking in particular at price controls on interchange fees and merchant discount rates (MDRs). While intended to reduce costs for merchants and consumers, the evidence shows these price controls impede competition and harm consumers.
For a payment network to be self-sustaining, there must be sufficient participation on both sides of the market—i.e., by both buyers and sellers. If too few sellers accept a particular form of payment, buyers will have little reason to adopt it. Likewise, if too few buyers hold a particular form of payment, sellers will have little reason to accept it. At the same time, payment networks must cover their costs of operation, including credit risk, monitoring costs, fraud risk, and investments in innovation. Payment networks typically address these two problems (optimizing participation and covering costs) simultaneously through various fees and incentives, thereby maximizing value to all participants.
Maximizing value often entails that one side of the market (usually, the merchants) subsidizes the other side (consumers) through an “interchange fee” received by the issuing bank from the acquiring bank. The interchange fee covers a much wider range of costs than the operational costs mentioned above. Specifically, it typically includes issuer costs associated with collection and default, as well as many of the additional benefits that cardholders typically receive, including various kinds of insurance and such rewards as cashback rewards and airline miles. The interchange fee, in turn, is typically covered by fees charged by the merchant’s acquiring bank (see Figure 1), known as the merchant discount rate (MDR) or merchant service charge (MSC).
Caps on interchange fees and/or MDR are price controls, which have the effect of reducing the incentive to supply the product subject to that control. Many countries have introduced price controls on interchange fees, and these have been much-studied. Section II presents a summary of the evidence of the effects of price controls on interchange fees.
By contrast, relatively few countries have imposed price controls on MDR and the effects of such price controls have rarely been scrutinized.[1] Section III thus offers an initial assessment of such effects. Finally, Section IV offers conclusions and policy recommendations.
This section considers the effects of price controls on interchange fees. While more than 30 jurisdictions have imposed such price controls, we focus on the jurisdictions for which we have the best evidence.[2] While each jurisdiction and each price control is unique, the effects appear to generalize readily. Therefore, the limited selection of jurisdictions here should be seen as typical examples.
This section begins with a brief description of the specific form price controls took in each jurisdiction. That is followed by a description of the response by (issuing) banks. Finally, the effects on consumers are evaluated.
Various jurisdictions have taken a variety of approaches to the imposition of price controls on interchange fees. The following are examples of some of the better-studied interventions.[3] These examples show what happens in the period immediately following the introduction of interchange-fee price controls. While some price controls have been repealed or changed, their effects are most transparent in the immediate aftermath of their implementation, and the inclusion of these examples thus remains instructive.
Spain imposed caps on interchange fees for both credit and debit cards through agreements with merchant associations and card schemes in two distinct phases: the first ran from 1999 to 2003, the second from 2006 to 2010.[4] During the first phase, caps were initially set at 3.5%, falling to 2.75% in July 2002. Caps were much lower during the second phase and were lower for large banks (over €500 million), whose credit-card interchange fees were capped at 0.66% in 2006, falling to 0.45% by 2010, than for small banks (under €100 million), whose credit-card interchange fees were capped at 1.4% in 2006, falling to 0.79% in 2010.
The Reserve Bank of Australia (RBA) introduced caps on interchange fees for credit cards in 2003 under a “cost-based framework,” which adjusted interchange fees based on processing costs. As a result, the RBA aimed in the first instance to reduce interchange fees by 40%, from an average of 0.95% in 2002 to 0.6% in 2003.[5]
Under a provision of the Dodd-Frank Wall Street Reform Act of 2010 known commonly as the “Durbin amendment,” the U.S. Federal Reserve imposed caps on debit-card interchange fees for large banks, as well as routing requirements for all debit-card issuers.[6] As a result, debit-card-interchange fees fell by about 50% for large banks almost immediately. Interchange fees on debit cards issued by smaller banks and credit unions initially fell by a smaller amount, and interchange fees on single-message (PIN) debit cards have now fallen to similar levels as PIN debit cards issued by larger banks.[7]
In 2015, the EU capped fees at 0.2% for debit cards and 0.3% for credit cards.[8] These are hard caps with few exceptions, and those rates rapidly became the norm for most transactions (with the exception of some domestic schemes that offer lower rates).[9]
Faced with potentially large losses of revenue, banks adopted numerous strategies to limit their losses, including, most notably:
Banks commonly increased other fees, including annual-card fees, account-maintenance fees, late fees, and interest on loans and credit cards. For example, in the United States, banks raised monthly account-maintenance fees and increased the minimum balance needed for a fee-free account.[10] In the EU, banks increased other fees and interest rates.[11]
Banks reduced the rewards and benefits associated with those cards that were subject to price controls. This included reducing or eliminating cashback rewards, points, and other incentives that were previously funded, in part, by interchange fees. For example, U.S. banks subject to the Durbin amendment generally eliminated debit-card rewards. In Australia, meanwhile, the average value of rewards fell by about 30%.[12]
Some banks shifted their focus to products not affected by the caps. In the United States, where the Durbin amendment applied only to debit cards, banks shifted their promotional efforts toward credit cards. In Australia, banks issued “companion” cards on three-party networks that were initially exempt. In some EU jurisdictions, banks have promoted business credit cards, which are exempt.[13]
Interchange-fee caps make the vast majority of consumers worse off, especially those with lower incomes. This outcome primarily arises from several interconnected factors:
As noted, in response to the reduction in interchange fees, banks have increased a range of fees, including higher account-maintenance charges (and higher minimum-balance requirements to qualify for free accounts); larger overdraft fees; increased interest rates on loans and credit cards; and higher annual fees on credit cards. These increased fees have disproportionately affected lower-income consumers, who may struggle more to maintain minimum-balance requirements or avoid overdrafts.[14]
The reductions in rewards and other benefits on cards subject to interchange-fee caps amount to a direct pecuniary loss for millions of consumers. Often, these losses far exceed the reduction in interchange fees that cause them. A case in point is insurance: credit-card-issuing banks are typically able to negotiate volume-based discounts on insurance, which means they pay less than would an individual seeking his or her own policy. But if there simply is not sufficient revenue to cover the continuation of such benefits, issuers are forced to withdraw it, as many issuers in the EU have done.
Larger account fees and increased minimum-balance requirements have resulted in an increase in unbanked and underbanked households in the United States, particularly among lower-income consumers.[15] As a result, more households have become reliant on check-cashing services, payday loans, and other high-cost financial services.
While larger merchants save on transaction fees, due to the lower interchange fees, these savings are not fully passed on to consumers in the form of lower prices. The degree of pass-through can vary greatly, depending on the competitive dynamics of various retail sectors. But in most cases, merchants have passed through the reduced costs associated with lower interchange fees at a lower rate than banks have passed through losses in fee revenue, in the form of higher-priced accounts, cards and services, and reductions in rewards. As such, consumers are, on net, worse off.[16]
While the intended goal of interchange-fee caps may be to reduce merchants’ costs and generate savings for consumers, in practice, consumers see few, if any, retail-price reductions, even as they experience significantly reduced benefits from their payment cards, as well as increased banking costs.
This section explores the effects of caps on merchant discount rates. As noted earlier, it is difficult to draw broad conclusions of the kind we were able to draw in Section II on the effects of interchange-fee caps. This is both because of the relative rarity of MDR caps, as well as the fact that they have—in the two cases examined here—coincided with other policy changes and broader economic and social phenomena that simultaneously have had significant effects on the payments system. The two case studies nonetheless offer salutary lessons about the problems inherent in imposing price controls on payment fees.
India’s MDR caps, which date back to 2012, were put in place as part of a series of interventions whose broad objective was to increase access to finance and shift transactions from paper to electronic money. These initiatives included (in order of implementation): a digital ID (launched in 2010); a domestic-card scheme and debit card (RuPay) with MDR caps (implemented in 2012); and a domestic faster-payments system (UPI, launched in 2016) with zero MDR for most transactions. This section focuses primarily on the implementation of UPI, its MDR caps, and the implications for consumers, merchants, and payment-service providers.
Until 2015, the two largest companies offering mobile phone-based payment services in India were Paytm and MobiKwik, which both relied on MDR to facilitate their expansion. MDR enabled these services to offer consumers cashback rewards and other incentives. MobiKwik signed up 1.5 million merchants and 55 million registered users by 2015,[17] while Paytm had 100 million registered accounts in 2015.[18]
Payment services are the core of Paytm’s business, contributing 58% of its revenue in Q3 2023 (although it fell slightly in Q1 2024).[19] These services arise from users making payments from mobile wallets stored on Paytm’s platform, using debit cards and credit cards. The company charges merchants an MDR that ranges from 0.4% to 2.99% of the transaction amount, depending on the payment type (for small-to-medium-size businesses).[20] MobiKwik, meanwhile, generates revenue from commissions and advertisements from its Zaak payment-gateway franchise subsidiary,[21] as well as loans—including short-term credit, buy-now-pay-later, and personal loans—and investment advice.[22] Of note, Zaak is also highly reliant on MDR as a source of revenue.[23]
In 2016, the National Payments Corporation of India (NPCI), a public-private partnership between the Reserve Bank of India (RBI) and the Indian Banks Association (IBA), launched the Unified Payment Interface (UPI), an open-source interoperable API that facilitates real-time transfers between individuals with accounts at participating banks that have integrated the API into their smartphone apps.[24] NPCI also built its own app, BHIM UPI, that is available directly and can also be white-labelled by banks and PSPs.[25]
By any measure, UPI has been enormously successful. In April 2024, more than 80% of all retail payments by volume and about 30% by value were made using UPI.[26]
PhonePe, which launched in 2016, and Google Pay, which launched in India in 2017, have from the outset operated exclusively on UPI. PhonePe launched as a wholly owned subsidiary of Flipkart, India’s largest online marketplace. This enabled it to leverage the marketplace’s then-100 million users, as well as subsequent growth of Flipkart’s user base.[27] Although PhonePe has now separated from Flipkart, it is still owned by Walmart, which bought Flipkart in 2018, and is thus able to leverage the retail giant’s merchant ecosystem.
Google, meanwhile, was able to leverage its brand recognition and to monetize Google Pay through a combination of advertising and its local online marketplace. It is noteworthy that, in a 2023 survey, Google was ranked the top brand in India, followed by Amazon and YouTube (which is owned by Google).[28]
PhonePe is now the largest payment network in India, with approximately 200 million active users; Paytm ranks second, with approximately 100 million active users;[29] Google Pay is third, with about 67 million active users;[30] and MobiKwik is fourth, with 35 million active monthly users in 2023.[31]
In April 2024, PhonePe and Google Pay together represented 87% of UPI transactions by volume and value (Table 1). Paytm was the third-largest payment app on UPI, representing 8% of transactions and 6% of value. The fourth-largest app was CRED, which is a members-only app aimed at individuals with higher credit scores.[32] Together, these top four apps represented 96.5% of transaction volume and 95.5% of transaction value. The remaining apps combined all had less than 5% market share between them, and none had more than 1% individually.[33]
SOURCE: NPCI
Since UPI transactions represented about 80% of India’s retail volume, this means that the combination of Google Pay and PhonePe represented more than 70% of all non-cash retail transactions in India by volume.
The reason such as high proportion of UPI payments come from the top four apps is that their operators have been able to monetize transactions and encourage adoption on both sides of the market without relying on MDR. NPCI prohibits MDR for most applications (exceptions are pre-paid debit and rechargeable mobile wallets, which since April 2023 have been permitted to charge up to 1.1% in MDR).[34]
These MDR caps on UPI have, however, made it less economically viable for payment-services providers (PSPs) to offer such incentives for consumers. Indeed, Paytm has recently switched from offering cashback rewards to consumers to offering cashback rewards to merchants—presumably because it realizes it has to compete with other payments ecosystems that run on UPI and therefore charge zero MDR.[35]
Like the interchange-fee caps explored in Section II, MDR caps change the economics of payment systems by reducing the ability of card issuers and payment-app operators to balance the two sides of the market through cross-subsidies. These effects became most visible after UPI went live in 2016 with zero MDR.
As noted, both PhonePe and Google Pay were able to leverage existing networks to attract both merchants and users (Flipkart, in the case of PhonePe, and Google’s search engine and other products, in the case of Google Pay). Having built a significant base of participants on both sides of the market, the companies have been able to monetize their payment systems through product advertising, upselling of related products, and in-app transactions, thereby reinforcing the network effects.
While MDR is prohibited on UPI, PhonePe usually charges a 2% transaction fee for its online-payment gateway service. Acting as a payment gateway carries little counterparty or credit risk, and is typically offered in other jurisdictions for a small flat fee. The 2% charged by PhonePe therefore effectively goes straight to the bottom line, or can be used to cross-subsidize participation, thereby further enhancing the PSPs’ market share. Indeed, in July 2023, PhonePe began offering its payment gateway for free to new customers (an own-side subsidy: existing users subsidize new users).[36]
Google Pay, meanwhile, has offered cashback incentives for use of the service on apps within its own (Android) ecosystem.[37] This encourages the use of Google Pay in much the same way that traditional rewards offer incentives to use other payment systems. The merchant beneficiaries are, however, limited to participants in its app system, for which Google charges a 30% transaction fee.
While Paytm’s share of UPI is low compared to PhonePe and Google Pay, it can monetize such transactions both by providing add-on financial services, such as insurance and investments, as well as through the MDR it charges on non-UPI transactions.[38] Paytm has also built a rewards program for merchants that encourages participation in its marketplace.[39]
Finally, CRED has partnered with a range of high-end brands to undertake targeted advertising, the revenue from which enables CRED to offer rewards to users of various kinds, including cashback rewards.[40]
While UPI has likely contributed to increased financial inclusion, the prohibition on MDR for most types of transactions has distorted the entire market toward merchants affiliated with the large mobile-payment ecosystems (PhonePe, Google, and Paytm) and a payment network targeted at higher-income customers (CRED). Meanwhile, this has come at a huge price for the majority of banks and other PSPs that facilitate payments on UPI. The Payments Council of India estimates that its members lose 55 billion rupees (US$660 million) annually as a result of the zero MDR on UPI and RuPay transactions.[41] This is effectively a transfer from those banks to the companies whose apps monetize UPI transactions.
India’s government partly offsets this loss through a subsidy to UPI participants of between 15 and 25 billion rupees.[42] But this amounts to a subsidy to PhonePe, Google, Paytm, and CRED, which is odd. Moreover, experience with other systems that impose restrictions on payment-transaction fees suggests that banks will seek to recover these losses via other fees.[43] To the extent that such additional fees fall on lower-income account holders, the effect on financial inclusion is likely to be negative.
India’s government has also announced that it intends to cap the share of UPI transactions for any one service provider to 30% by the end of 2024, with the goal of reducing the dominance of Google Pay and PhonePe.[44] It remains unclear how such caps will be implemented, but it is almost certain that whatever mechanism is adopted would cause other harmful effects. Indeed, there is something slightly absurd about introducing a cap on participation in order to address the perverse consequences of caps on MDR.
Given that the MDR caps are the cause of Google Pay and PhonePe’s combined dominance, a far better solution would be to lift those caps. Indeed, based on the evidence adduced here, removing the MDR caps would likely unleash competition and innovation. Instead of being dominated by a few giant players, UPI would become what its visionaries intended: an inclusive platform that facilitates participation by a wide range of players. The platform could then further expand access to payments, enhance smaller merchants’ ability to compete, and improve financial inclusion.
Costa Rica introduced price controls on payment cards in 2020. Legislative Decree No. 9831 authorized the Central Bank of Costa Rice (BCCR) to regulate fees charged by service providers on “the processing of transactions that use payment devices and the operation of the card system.”[45] The legislation’s stated objective was “to promote its efficiency and security, and guarantee the lowest possible cost for affiliates.” BCCR was tasked with issuing regulations that would ensure the rule is “in the public interest” and guarantee that fees charged to “affiliates” (i.e., merchants) are “the lowest possible … following international best practices.”
Starting Nov. 24, 2020, BCCR set maximum interchange fees for domestic cards at 2.00% and maximum MDR at 2.50%. Over a four-year period, BCCR has gradually ratcheted down both MDR and interchange-fee caps, as shown in Table 2.
An unusual feature of BCCR’s regulation is the simultaneous cap on both MDR and interchange fees, which has the effect of limiting revenue to both acquiring banks and issuing banks. This has likely reduced investments by issuers and acquirers and led to lower levels of system efficiency and speed, and possibly to increased fraud.
It is also worth noting that both interchange fees and MDR vary according to merchant type and location, in large part because the risk of fraud varies among different types of merchants. There is a danger, therefore, that imposing price controls on both MDR and interchange fees could make it unprofitable for acquirers to process payments for some riskier merchants. In other words, in its attempt to reduce merchant costs, BCCR may inadvertently (but predictably) prohibit some merchants from being able to accept payment cards. This is neither efficient, nor is it in the public interest.
Looking at the trajectory of the mean and median MDRs for various merchant categories in Costa Rica before price controls were imposed (as shown in Figures 1 and 2), MDRs were, on average, quite high (a mean of about 4%) but the medians were even higher (ranging from 4% to 10% for all categories except gas stations and passenger transportation). This significant difference between the mean and median MDRs suggests either that a large proportion of merchants represented a particularly high risk (e.g., from fraud and/or chargebacks) or that there was a lack of competition among acquiring banks (and perhaps even collusion)—or perhaps both.
SOURCE: Author’s calculations based on data from BCCR
If the previously high MDRs were a function of merchant-associated risk, capping MDRs would be expected to cause acquiring banks to drop some merchants. The data, however, show that the number of merchants increased from 2020 to 2022, which suggests that lack of competition among acquirers is a more likely explanation.[46]
To the extent that these high MDRs reflect a lack of competition among acquiring banks, the appropriate response would have been to seek to understand what was causing this lack of competition and then to remedy that directly. For example, if the lack of competition arose from regulations imposed by BCCR, it would be incumbent on BCCR to modify its regulations to reduce barriers to competition. Capping MDR does not address the underlying problem; indeed, it likely makes it worse, by inhibiting acquirers from being able to differentiate themselves on price or quality.
In competitive markets without price controls, prices evolve in ways that tend to maximize value for all participants. In payment networks, interchange fees play an important role, enabling issuers to develop appealing and competitive products with features that range from cashback rewards to travel insurance. This encourages customers to use the card or app in question, which, in turn, benefits merchants who see greater sales. The fees also facilitate associated innovations, such as AI-based fraud detection, contactless payments, and online token vaults.
When governments impose price controls on payment fees—whether in the form of caps on interchange fees or on MDR, or both—bank revenue from card transactions falls. Issuers (and acquirers, in the case of MDR caps) respond by increasing other fees, reducing card benefits, and reducing investments in improvements. The ecosystem becomes distorted, unbalanced, and fundamentally less competitive.
The beneficiaries of such interventions tend to be larger merchants and other participants in the system (including larger financial technology, or “fintech,” players). These players can leverage and reinforce their loyal customer base, and often charge fees for services (such as payment gateways) that are as high or higher than interchange fees, and even MDR.
India’s government recognizes the anticompetitive nature of its MDR caps, but appears to think that this is best-addressed by introducing new caps on participation. Costa Rica, meanwhile, appears to have suffered from a lack of competition among merchant acquirers, which drove up the cost of MDR—leading it to introduce caps on MDR.
But, in both cases, regulation is the problem, not the solution. In India’s case, various regulations—especially the caps on MDR for UPI transactions, as well as the government subsidies to UPI—have resulted in heavy concentration and impeded competition from fintech startups. Meanwhile, in Costa Rica, existing regulatory barriers likely impeded competition in the acquisition market, which enabled acquirers to charge excessive rates. This has prompted BCCR to impose MDR and interchange-fee caps that, in turn, have impeded competition in issuance.
The biggest losers from such interventions tend to be lower-income consumers, who end up paying higher bank fees and leaving—or not entering—the banking system. But there are many other losers, including the majority of consumers, and the many potential competitors that are excluded from participation because they are unable to monetize their investments via interchange and/or MDR fees.
Governments should not distort markets in these ways. Quite the opposite: they should be as neutral as possible. Rather than imposing price controls on payment systems, they might look to review and repeal existing government-created barriers to financial inclusion. These could include licensing requirements for banks that limit competition and enable acquirers to charge abnormal MDR rates.
In other words, rather than layer additional distorting regulations atop existing regulations, further harming the operation of complex private-market ecosystems, they should look for ways to reduce government-imposed barriers to competition. And, generally, they should limit themselves to the production of genuine public goods, such as courts and identity registers. Doing so will enable greater participation, competition, and innovation, which will drive financial inclusion.
[1] Other jurisdictions, such as Denmark and China, also have imposed restrictions on MDR/MSC, but this author was unable to adduce sufficient information about the nature and effects of these interventions to develop substantive analyses.
[2] We draw extensively on our earlier review: Julian Morris, Todd J. Zywicki, & Geoffrey A. Manne, The Effects of Price Controls on Payment-Card Interchange Fees: A Review and Update, (ICLE White Paper 2022-03-04 & George Mason L. & Econ. Research Paper No. 22-07, 2022), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4063914. See also Fumiko Hayashi & Jesse Leigh Maniff, Public Authority Involvement in Payment Card Markets: Various Countries, August 2020 Update, Fed. Res. Bank of Kan. City (August 2020), available at https://www.kansascityfed.org/documents/6660/PublicAuthorityInvolvementPaymentCardMarkets_VariousCountries_August2020Update.pdf.
[3] Morris et al., supra note 2.
[4] Juan Iranzo, Pascual Fernández, Gustavo Matías, & Manuel Delgado, The Effects of the Mandatory Decrease of Interchange Fees in Spain (Munich Personal RePEc Archive, MPRA Working Paper No. 43097, 2012), available at https://mpra.ub.unimuenchen.de/43097/1/MPRA_%20paper_43097.pdf.
[5] Press Release, Reform of Credit Card Schemes in Australia, Res. Bank of Austl. (Aug. 27, 2002), https://www.rba.gov.au/media-releases/2002/mr-02-15.html.
[6] H.R.4173 – Dodd-Frank Wall Street Reform and Consumer Protection Act, s.1075(a)(3); Debit Card Interchange Fees and Routing; Final Rule, 76 Fed. Reg. 43,393-43,475, (Jul. 20, 2011).
[7] Todd J. Zywicki, Geoffrey A. Manne, & Julian Morris, Unreasonable and Disproportionate: How the Durbin Amendment Harms Poorer Americans and Small Businesses, Int’l Cntr For L. & Econ. (Apr. 25, 2017), available at https://laweconcenter.org/wp-content/uploads/2017/08/icle-durbin_update_2017_final-1.pdf.
[8] Regulation (EU) 2015/751 of the European Parliament and of the Council of 29 April 2015 on Interchange Fees for Card-Based Payment Transactions, 2015, O.J. (L 123) 1, 10-11 (hereinafter “IFR”).
[9] Ferdinand Pavel et al., Study on the Application of the Interchange Fee Regulation: Final Report 89, European Commission Directorate-General for Competition (2020), https://op.europa.eu/s/zKl2.
[10] Mark D. Manuszak & Krzysztof Wozniak, The Impact of Price Controls in Two-Sided Markets: Evidence From US Debit Card Interchange Fee Regulation (Bd. of Governors of the Fed. Res. Sys. Fin. & Econ. Discussion Series, Working Paper No. 2017-074, 2017); Vladimir Mukharlyamov & Natasha Sarin, Price Regulation in Two-Sided Markets: Empirical Evidence From Debit Cards (SSRN Working Paper, 2019), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3328579.
[11] Interchange Fee Regulation (IFR) Impact Study Report, Edgar Dunn & Co. (Jan. 21, 2020), https://www.edgardunn.com/reports/interchange-fee-regulation-ifr-impact-assessment-study-report.
[12] Iris Chan, Sophia Chong, & Stephen Mitchell, The Personal Credit Card Market in Australia: Pricing Over the Past Decade, Res. Bank Of Austl. Bull. (2012), available at https://www.rba.gov.au/publications/bulletin/2012/mar/pdf/bu-0312-7.pdf.
[13] IFR, supra note 8, Art. 1(3)(a).
[14] Mukharlyamov & Sarin, supra note 10.
[16] Iranzo et al., supra note 4 at 34-37; Ian Lee, Geoffrey A. Manne, Julian Morris, & Todd J. Zywicki, Credit Where It’s Due: How Payment Cards Benefit Canadian Merchants and Consumers, and How Regulation Can Harm Them, Macdonald-Laurier Institute 1, 27 (2013); Morris, Zywicki, & Manne, supra note 7 at 23-29.
[17] Shabana Hussain, MobiKwik’s Journey and the Path Ahead, Forbes India (Apr. 6, 2015), http://forbesindia.com/article/work-in-progress/mobikwiks-journey-and-the-path-ahead/39905/1 .
[18] Paytm Reaches 100 Million Users, Business World (Aug. 11, 2015), https://businessworld.in/article/paytm-reaches-100-million-users–84698.
[19] Press Release, Paytm’s Earning’s Release for Quarter and Year Ending March 2024, Paytm (May 22, 2024), available at https://paytm.com/document/ir/financial-results/Paytm_Earnings-Release_INR_Q4_FY24.pdf.
[20] Paytm’s Pricing, Paytm, https://business.paytm.com/pricing (last visited Jun. 07, 2024).
[21] MobiKwik Consolidated Financial Statement, MobiKwik (2023), available at https://documents.mobikwik.com/files/investor-relations/statements/mobikwik/Consolidated-Financials-Sept2023.pdf; Report on the Audit of Special Purpose Interim Financial Statements, Tattvam & Co. (Dec. 31, 2023), available at https://documents.mobikwik.com/files/investor-relations/statements/zaakpay/zaakpay-financials-sept2023.pdf; Subsidiary Financials, MobiKwik, https://www.mobikwik.com/ir/subsidiary-financials (last visited Jun. 7, 2024); Status of Applications Received from Online Payment Aggregators (PAs) Under Payment and Settlement Systems Act, 2007, Res. Bank of India, https://www.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=4236 (last updated Jun. 1, 2024).
[22] Id., Res. Bank of India.
[23] Pratik Bhakta, MobiKwik to Add Muscle to Its Payment Gateway Business, The Economic Times (May 13, 2017), https://economictimes.indiatimes.com/small-biz/startups/mobikwik-shifting-focus-to-payment-gateway-space/articleshow/58655807.cms?from=mdr.
[24] Unified Payments Interface (UPI), National Payments Corporation of India (2024), https://www.npci.org.in/what-we-do/upi/product-overview; UPI Live Members, National Payments Corporation of India (2024), https://www.npci.org.in/what-we-do/upi/live-members.
[25] BHIM, https://www.bhimupi.org.in (last visited Jun. 7, 2024); Pratik Bhakta, BHIM to Be the Right Platform for Small Banks to Enter Payment Space, The Economic Times (Feb. 3, 2017), https://economictimes.indiatimes.com/small-biz/security-tech/technology/bhim-to-be-the-right-platform-for-small-banks-to-enter-payment-space/articleshow/56945820.cms?from=mdr.
[26] Payment System Indicators, Res. Bank of India (Apr. 2024), https://www.rbi.org.in/Scripts/PSIUserView.aspx?Id=35.
[27] Alnoor Peermohamed, Flipkart Grows User Base to 100 million, Business Standard (Jun. 6, 2024), https://www.business-standard.com/article/companies/flipkart-grows-user-base-to-100-million-116092100216_1.html.
[28] Gaurav Laghate, Google, Amazon, YouTube Top India brands, Livemint (Jun. 27, 2023), https://www.livemint.com/companies/news/google-amazon-youtube-top-india-brands-11687887362055.html.
[29] Paytm Surpasses 100 Million Monthly Transacting Users for the First Time in Q3 FY24, Livemint (Jan. 22, 2024), https://www.livemint.com/companies/news/paytm-surpasses-100-million-monthly-transacting-users-for-the-first-time-in-q3-fy24-11705932856486.html.
[30] Michael G. William, How Many People Use Google Pay in 2023?, Watcher Guru (Sep. 14, 2023), https://watcher.guru/news/how-many-people-use-google-pay-in-2023#google_vignette.
[31] MobiKwik Continues Profitable Streak for Second Quarter in a Row, The Economic Times (Oct. 05, 2023), https://economictimes.indiatimes.com/tech/technology/mobikwik-continues-profitable-streak-for-second-quarter-in-a-row/articleshow/104183594.cms?from=mdr.
[32] CRED, https://cred.club/ipl (last visited Jun. 07, 2024).
[33] Eight other apps had between 0.25% and 0.75% of transaction volume and/or value: Amazon Pay, ICICI Bank Apps, Fampay, Kotak Mahindra Bank Apps, HDFC Bank Apps, WhatsApp, BHIM, and Yes Bank Apps.
[34] Upasana Taku, NPCI’s 1.1% Interchange Fee on UPI Payments Via Wallet – The Watershed Moment for Fintech in India, The Times of India (May 15, 2023), https://timesofindia.indiatimes.com/blogs/voices/npcis-1-1-interchange-fee-on-upi-payments-via-wallet-the-watershed-moment-for-fintech-in-india.
[35] Pratik Bhakta, Inside Paytm’s Cashback Offers for Retailers, The Economic Times (Jul. 7, 2023), https://economictimes.indiatimes.com/tech/startups/in-through-the-other-door-inside-paytms-cashback-offers-for-retailers/articleshow/101551675.cms?from=mdr.
[36] Mayur Shetty, PhonePe Cuts Fees for Payment Gateway Services, The Times of India (Jun. 14, 2023), https://timesofindia.indiatimes.com/business/india-business/phonepe-cuts-fees-for-payment-gateway-services/articleshow/100986915.cms.
[37] Manish Singh, Google’s New Plan to Push Google Pay in India: Cashback Incentives in Android Apps, TechCrunch (May 16, 2019), https://techcrunch.com/2019/05/16/google-pay-india-android-cashback.
[38] Paytm, supra note 20.
[39] An Overview of Merchant Discount Rate Charges, AMLegals (Mar. 15, 2024), https://amlegals.com/an-overview-of-merchant-discount-rate-charges.
[40] CRED Pay, https://cred.club/cred-pay/onboarding (last visited Jun. 7, 2024).
[41] Roll Back Zero Merchant Discount Rate on UPI, Rupay Debit Card Payments, Industry Body Payments Council of India Writes to Finance Ministry, The Indian Express (Jan. 23, 2022), https://indianexpress.com/article/business/banking-and-finance/merchant-discount-rate-rollback-on-upi-rupay-debit-cards-7737229.
[42] Pratik Bhakta, Fintechs Await Government Word on MDR Subsidy Allocation, The Economic Times (Feb. 22, 2024), https://economictimes.indiatimes.com/tech/technology/fintechs-await-government-support-for-promoting-digital-payments-for-current-fiscal/articleshow/107891943.cms?from=mdr.
[43] Morris et al., supra note 2.
[44] Ajinkya Kawale, NPCI to Review by End of Year Decision on 30% UPI Market Share Cap, Business Standard (Apr. 19, 2024), https://www.business-standard.com/markets/news/npci-to-review-30-market-share-cap-decision-by-year-end-124041901059_1.html.
[45] Author’s translations from the Spanish original are approximate.
[46] Fijación Ordinaria de Comisiones Máximas del Sistema de Tarjetas de Pago, Banco Centrale de Costa Rica (Oct. 2023), 12, available at https://www.bccr.fi.cr/en/payments-system/DocCards/Estudio_tecnico_2023_fijacion_ordinaria_comisiones_CP.pdf.
Scholarship Abstract Concerns over the ownership, use, security, and flows of consumer data information are not new. Yet the dominance of the Internet and electronic payments . . .
Concerns over the ownership, use, security, and flows of consumer data information are not new. Yet the dominance of the Internet and electronic payments has elevated such concerns to a high level. Traditionally there was perceived to be a tradeoff between the flow of information necessary for the consumer financial system to work well (such as to solve information asymmetries necessary in order to make credit-granting decisions) and consumer control over their data and keeping their information private. Data security approaches historically pursued a state “fortress” model that rested on the ability of consumers to keep private a small amount of information the consumer uniquely knew, such as a PIN or password.
Today, however, it is becoming apparent that this static model is no longer viable and can be expected to grow less viable with the growth of artificial intelligence and machine-learning. But such approaches have costs as well—not only are they often more cumbersome, when the fortress walls are breached these systems can be slower to adapt and can result in increased harm to consumers on the back end. Some people have suggested that we respond to these emergent threats by trying to build taller and thicker fortress walls and other static, such as the use of biometric identification. The approach suggested here, by contrast, attempts to model what a more dynamic approach to information security would look like and how such a system would be dependent on more data flows rather than less. I suggest some areas of current and proposed regulation that should be reexamined in light of the analysis presented here.
Read at SSRN.
Regulatory Comments Executive Summary In this comment, we argue that the Federal Reserve Board’s interpretation of the Durbin amendment has had the opposite effect to that intended . . .
In this comment, we argue that the Federal Reserve Board’s interpretation of the Durbin amendment has had the opposite effect to that intended by the legislation. Specifically, it has harmed lower-income consumers and benefited the shareholders of large merchants. To understand how and why this has happened, we look at two aspects of the provision’s implementation: the price controls the Board imposed through Regulation II, and the competitive-routing requirement included in the Durbin amendment itself. We then consider the likely effects of the changes proposed in the NPRM and conclude that these will exacerbate the harms already inflicted by Regulation II. We encourage the Board to consider alternative approaches that would mitigate Regulation II’s harms, including raising or, ideally, eliminating the cap on interchange fees.
The International Center for Law & Economics (“ICLE”) thanks the Board of Governors of the Federal Reserve System (“Board”) for the opportunity to comment on this notice of proposed rulemaking (“NPRM”), which calls for updates to components of the interchange-fee cap established by Regulation II.[1]
Section 1075 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”)—commonly referred to as the “Durbin amendment”—required the Board to issue regulations that would limit debit-card interchange fees charged by lenders with assets of more than $10 billion (“covered banks”), such that:
The amount of any interchange transaction fee that an issuer may receive or charge with respect to an electronic debit transaction shall be reasonable and proportional to the cost incurred by the issuer with respect to the transaction.[2]
Sen. Richard Durbin (D-Ill.) stated in 2010 that his amendment “would enable small businesses and merchants to lower their costs and provide discounts for their customers.”[3] Yet the evidence to date demonstrate that, in practice, the provision has done little, if anything, to reduce costs for small businesses and merchants; indeed, many have seen costs rise.[4] Meanwhile, consumers have seen little, if any, savings from merchants, and have been harmed by higher banking fees.[5]
These problems are, at least in part, a consequence of the way the Board chose to interpret the phrase “reasonable and proportional to the cost incurred by the issuer with respect to the transaction.” Specifically, as the Board notes in its summary of the present NPRM:
Under the current rule, for a debit card transaction that does not qualify for a statutory exemption, the interchange fee can be no more than the sum of a base component of 21 cents, an ad valorem component of 5 basis points multiplied by the value of the transaction, and a fraud-prevention adjustment of 1 cent if the issuer meets certain fraud-prevention- standards.
The Board now proposes to reduce further the interchange fees that covered banks may charge for debit-card transactions. Specifically:
Initially, under the proposal, the base component would be 14.4 cents, the ad valorem component would be 4.0 basis points (multiplied by the value of the transaction), and the fraud-prevention adjustment would be 1.3 cents for debit card transactions performed from the effective date of the final rule to June 30, 2025.
In this comment, we question the Board’s interpretation of the underlying legislation by citing, among other things, research conducted by employees of the Board and published by the Board.
The heart of the matter is the meaning of “reasonable and proportional to the cost incurred by the issuer with respect to the transaction.” In most respects, the Board has chosen to interpret this phrase narrowly to refer to the pecuniary costs directly associated with the electronic processing of each transaction ($0.21 plus 0.05% of the value of the transaction). But even in deploying this narrow interpretation, the Board has been inconsistent, as:
This latter component clearly is not transaction-specific, as it is intended to cover the cost of investments made in security infrastructure.
The Board’s approach to “cost” fails to consider the two-sided nature of payment-card markets. A 2017 staff working paper by Board economists Mark D. Manuszak and Krzysztof Wozniak notes:
Interchange fees play a central role in theoretical models of payment card networks, which emphasize the card market’s two-sided nature (for example, Rochet and Tirole (2002)).[7] On one side of the market, interchange fees alter acquirers’ costs, influencing the transaction fees they charge merchants. On the other side of the market, inter- change fees provide a source of revenue that defrays issuers’ costs of card services for accountholders, and, thus, influence fees that banks charge accountholders. As a result, these theoretical models broadly predict that a reduction in interchange fees will induce issuers to increase prices for accountholders. However, theoretical models of two-sided markets rely on an overly simple characterization of issuers, which diverges from reality in three important ways. First, issuers use nonlinear, account-based pricing rather than per-transaction fees typically assumed by the theory but rarely observed in reality. The theoretical literature on nonlinear pricing emphasizes the sensitivity of consumer demand to different price components. For the debit card industry, it predicts that higher costs will result in increases in prices for which consumers’ demand is less sensitive, and lower or no rises in prices to which the demand is more sensitive. Second, issuers are multiproduct firms, cross-selling a variety of products in addition to card transactions. The theoretical literature on multiproduct pricing predicts that a firm’s price for one good will internalize its impact on the demand for the firm’s other products. In the debit card industry, this implies that, since a bank is best positioned to offer additional services to consumers who are already its accountholders, the price for such an account is less likely to reflect higher costs than it would otherwise. Finally, issuers are heterogeneous firms, subject to idiosyncratic cost shocks based on their status under the regulation, and compete for customers in the market for banking services. An issuer’s prices are not determined in isolation by its costs and the market demand, but rather jointly with other issuers’ prices…. [8]
Interchange fees play a central role in theoretical models of payment card networks, which emphasize the card market’s two-sided nature (for example, Rochet and Tirole (2002)).[7] On one side of the market, interchange fees alter acquirers’ costs, influencing the transaction fees they charge merchants. On the other side of the market, inter- change fees provide a source of revenue that defrays issuers’ costs of card services for accountholders, and, thus, influence fees that banks charge accountholders. As a result, these theoretical models broadly predict that a reduction in interchange fees will induce issuers to increase prices for accountholders.
However, theoretical models of two-sided markets rely on an overly simple characterization of issuers, which diverges from reality in three important ways. First, issuers use nonlinear, account-based pricing rather than per-transaction fees typically assumed by the theory but rarely observed in reality. The theoretical literature on nonlinear pricing emphasizes the sensitivity of consumer demand to different price components. For the debit card industry, it predicts that higher costs will result in increases in prices for which consumers’ demand is less sensitive, and lower or no rises in prices to which the demand is more sensitive.
Second, issuers are multiproduct firms, cross-selling a variety of products in addition to card transactions. The theoretical literature on multiproduct pricing predicts that a firm’s price for one good will internalize its impact on the demand for the firm’s other products. In the debit card industry, this implies that, since a bank is best positioned to offer additional services to consumers who are already its accountholders, the price for such an account is less likely to reflect higher costs than it would otherwise.
Finally, issuers are heterogeneous firms, subject to idiosyncratic cost shocks based on their status under the regulation, and compete for customers in the market for banking services. An issuer’s prices are not determined in isolation by its costs and the market demand, but rather jointly with other issuers’ prices…. [8]
In the decade prior to the Dodd-Frank Act, banks had increased the availability of free checking accounts (Figure I) and reduced the fees on non-interest-bearing checking accounts (Figure II), which had widespread benefits. First, it enabled more people to open and maintain bank accounts, thereby reducing the proportion of unbanked and underbanked Americans. Second, it contributed to a shift toward electronic payments, as many consumers who previously lacked access to payment cards now had a debit card (Figure III). This shift was driven along further by banks offering rewards that encouraged the use of debit cards. Since the provision of checking accounts generates associated costs, banks that expanded their offerings of free and/or low-fee accounts had to recoup those costs elsewhere. They did so, in part, through revenue from interchange fees on debit cards.
In a 2014 staff working paper, Board economists Benjamin S. Kay, Mark D. Manuszak, and Cindy M. Vojtech found that Regulation II reduced annual interchange-fee revenue at covered banks by $14 billion.[9] Meanwhile, in their aforementioned 2017 paper, Manuszak and Wozniak showed that, following Regulation II’s implementation, covered banks sought to recoup the revenue lost due to lower interchange fees by increasing fees on checking accounts; reducing the availability of free checking accounts; and increasing the minimum balance required to maintain a free checking account. This resulted in “lower availability of free accounts, higher monthly fees, lower likelihood that the monthly fee could be avoided, and a higher minimum balance to avoid the fee.”[10]
Moreover, Manuszak and Wozniak show that “checking account pricing at covered banks appears primarily driven by the interchange fee restriction rather than other factors related to the financial crisis or subsequent regulatory initiatives.”[11] Finally, in the version of Kay et al.’s paper published in the Journal of Financial Intermediation, the authors “find that retail banks subject to the cap were able to offset nearly all of lost interchange income through higher fees on deposit services.”[12]
In a more recent study, Georgetown University economist Vladimir Mukharlyamov and University of Pennsylvania economist Natasha Sarin estimated that Regulation II caused covered banks to lose $5.5 billion annually, but that they recouped 42% of those losses from account holders. As a result:
the share of free checking accounts fell from 61 percent to 28 percent as a result of Durbin. Average checking account fees rose from $3.07 per month to $5.92 per month. Monthly minimums to avoid these fees rose by 21 percent, and monthly fees on interest-bearing checking accounts also rose by nearly 14 percent. These higher fees are disproportionately borne by low-income consumers whose account balances do not meet the monthly minimum required for fee waiver.[13]
SOURCE: Bankrate
SOURCE: Authors’ calculations based on data from Federal Reserve payment studies
In a letter to Senate Banking Committee Chairman Chris Dodd (D-Conn.), House Financial Services Committee Chairman Barney Frank (D-Mass.), and the conferees selected to finalize the Dodd-Frank Act, Durbin claimed that:
Under the Durbin amendment, the requirement that debit fees be reasonable does not apply to debit cards issued by institutions with assets under $10 billion. This means that Visa and MasterCard can continue to set the same debit interchange rates that they do today for small banks and credit unions. Those institutions would not lose any interchange revenue that they currently receive.[14]
Yet as can be seen clearly in Figure IV, average per-transaction debit-card interchange fees fell across the board. For covered issuers, average interchange fees per-transaction fell to the regulated maximum for both covered dual-message (signature) transactions and single-message (PIN) transactions immediately following implementation of Regulation II in October 2011. Meanwhile, adjusting for inflation, average fees per-transaction for exempt issuers fell by about 10% for dual-message transactions.
Average fees per-transaction for single-message transactions, however, fell by 30% over the course of eight years. By 2019, they were only marginally higher than the regulated maximum for covered banks, despite the claimed intent to protect smaller issuers from the effects of the debit-interchange cap. The cause of this decline was the addition of the following subsections to the Electronic Fund Transfer Act (EFTA):[15]
These changes, which were dictated by the Durbin amendment, enabled merchants to route transactions over lower-cost networks. That has effectively forced the networks subject to such competition—primarily single-message (PIN) networks—to reduce the fees set for exempt banks so that they are in line with those set for covered banks.
This has inevitably caused many exempt banks and credit unions to experience losses similar to those experienced by covered banks. Indeed, in some cases, the effects have been markedly worse, because smaller banks and credit unions lack the advantage of scale.
SOURCE: Federal Reserve, St. Louis FRED[16]
In a 2014 paper published by the Federal Reserve Bank of Richmond, Zhu Wang, Scarlett Schwartz, and Neil Mitchell analyzed the results of a then-recent merchant survey conducted by the Federal Reserve Bank of Richmond and Javelin Strategy & Research, which sought to understand the Durbin amendment’s effects on merchants and the response of those merchants. The authors found that, while some merchants enjoyed reductions following Regulation II’s implementation in the merchant-discount rate they paid, others saw their debit-card acceptance costs rise.[17] They also found an asymmetric response: merchants who saw their prices increase typically passed those increased costs onto their customers, while very few of those who saw their debit costs decrease passed those savings onto customers.
Using proprietary data from banks and one of the card networks, economists Vladimir Mukharlyamov and Natasha Sarin estimated that merchants passed through “at most” 28% of their debit-card interchange-fee savings to consumers.[18] The “at most” is worth qualifying: the authors base their analysis on savings at gas stations, but they note that:
It turns out, however, that the standard deviation of per-gallon gas prices ($0.252) is 168 times larger than the average per-gallon debit interchange savings ($0.0015). Relatedly, total Durbin savings for gas merchants amount to less than 0.07% of total sales. These points render the quantification of merchants’ pass-through with statistical significance virtually impossible. The existence of payment instruments exempt from Durbin and the presence of a fixed component in the regulation’s interchange-fee formula further complicate pass-through even for merchants willing to share savings, however small, with consumers.[19]
Meanwhile, as noted, they estimated that banks passed through 42% of their interchange-fee revenue losses to consumers. They estimate that the net result of this was a $4 billion transfer to merchants, of which $3.2 billion came directly from banks and $0.8 billion from consumers, who paid $2.3 billion more in higher checking fees, but received only $1.5 billion in lower retail prices.
In a 2014 ICLE paper, Todd Zywicki, Geoffrey Manne, and Julian Morris offered a back-of-the-envelope calculation of the best-case scenario for the net effect of Regulation II on the “average” American consumer:
In 2012, the average household spent $30,932 in total on food, apparel, transportation, entertainment, healthcare, and other items that could have been purchased using a payment card (out of a total household expenditure of $51,442). If all of those items were purchased on debit cards and all were purchased from larger retailers and those larger retailers passed on all their savings (averaging 0.7%), then the average household would have saved $216.50. And that is the absolute best case – and most unlikely – scenario. But now assume that average household has two earners, each with a bank account that was previously free but now costs $12 per month. In that case, the household’s costs would have risen by $71.50 as a result of the Durbin Amendment. In other words, even in the best case, lower-middle income and poorer households who have lost access to a free current account—which is likely a majority—will be worse off after the Durbin Amendment.[20]
While the average consumer likely fared poorly, Regulation II was, quite frankly, a disaster for many lower-income consumers. Using data from the Board’s Survey of Consumer Finances, Mukharlyamov and Sarin found that:
over 70 percent of consumers in the lowest income quintile (annual household income of $22,500 or less) bear higher account fees, since they fall below the average post-Durbin account minimum required to avoid a monthly maintenance fee ($1,400). In contrast, only 5 percent of consumers in the highest income quintile (household income of $157,000 or more) fall below this threshold.[21]
Worse, Regulation II almost certainly resulted in an increase in the number of unbanked Americans. Mukharlyamov and Sarin note:
Nearly 8 percent of Americans were unbanked in 2013, with nearly 10 percent of this group becoming unbanked in the last year. Using data from the FDIC National Survey of Unbanked and Underbanked Households, in Table 12 we show that immediately following Durbin there is a significant growth (81 percent increase relative to survey pre-Durbin) in the share of the unbanked population that credits high account fees as the main reason for their not having a bank account. This difference is significant at the 1 percent level. Respondents in states most impacted by Durbin (those with the highest share of deposits at banks above the $10 billion threshold) are most likely to attribute their unbanked status post-Durbin to high fees (over 15 percent of those surveyed in the highest Durbin tercile). The growth in the recently unbanked (those who had accounts previously but closed them within the last year) is also highest in states with the most Durbin banks, where the increase in account fees is most pronounced. As with the overall sample, these differences are significant at the 1 percent level. This suggests that at least some bank customers respond to Durbin fee increases by severing their banking relationship and potentially turning to more expensive alternative financial services providers such as payday lenders and check-cashing facilities.[22]
Nearly 8 percent of Americans were unbanked in 2013, with nearly 10 percent of this group becoming unbanked in the last year. Using data from the FDIC National Survey of Unbanked and Underbanked Households, in Table 12 we show that immediately following Durbin there is a significant growth (81 percent increase relative to survey pre-Durbin) in the share of the unbanked population that credits high account fees as the main reason for their not having a bank account. This difference is significant at the 1 percent level.
Respondents in states most impacted by Durbin (those with the highest share of deposits at banks above the $10 billion threshold) are most likely to attribute their unbanked status post-Durbin to high fees (over 15 percent of those surveyed in the highest Durbin tercile). The growth in the recently unbanked (those who had accounts previously but closed them within the last year) is also highest in states with the most Durbin banks, where the increase in account fees is most pronounced. As with the overall sample, these differences are significant at the 1 percent level. This suggests that at least some bank customers respond to Durbin fee increases by severing their banking relationship and potentially turning to more expensive alternative financial services providers such as payday lenders and check-cashing facilities.[22]
It is worth noting that the Board was well aware of the two-sided nature of payment-network markets and the implications for setting interchange fees prior to issuing Regulation II. A 2009 staff working paper by Robin A. Prager, Mark D. Manuszak, Elizabeth K. Kiser, and Ron Borzekowski stated:
A few characteristics of an efficient interchange fee are worth noting:
In general, an efficient interchange fee is not solely dependent on the cost of producing a card-based transaction nor is it equal to zero.
An efficient interchange fee may yield prices for card services to each side of the market that are “unbalanced” in the sense that one side pays a higher price than the other.
The efficient interchange fee for a particular card network is difficult to determine empirically.[23]
Based on the foregoing analysis, it appears clear that the optimal debit-card interchange fee is higher than that currently permitted for covered banks under Regulation II—and for exempt banks subject to Durbin’s routing mandates. It is, therefore, rather disconcerting that the Board would contemplate reducing the interchange fee further still in the NPRM to which this comment is addressed. If the Board wished to establish a “reasonable and proportional” fee for debit-card interchange, it would instead raise the cap. Indeed, since it remains “difficult to determine empirically” the efficient interchange fee for any card network, the Board should acknowledge that markets are the best mechanism to establish such fees, and remove the price controls altogether.
[1] Debit Card Interchange Fees and Routing, 88 Fed. Reg. 78100 (Nov. 14, 2023), https://www.federalregister.gov/documents/2023/11/14/2023-24034/debit-card-interchange-fees-and-routing.
[2] Pub. L. 111–203, 124 Stat. 1376 (2010), available at https://www.govinfo.gov/content/pkg/PLAW-111publ203/pdf/PLAW-111publ203.pdf.
[3] Press Release, Durbin Sends Letter to Wall Street Reform Conferees on Interchange Amendment, Office of Sen. Richard Durbin (May 25, 2010), https://www.durbin.senate.gov/newsroom/press-releases/durbin-sends-letter-to-wall-street-reform-conferees-on-interchange-amendment.
[4] Zhu Wang, Scarlett Schwartz, & Neil Mitchell, The Impact of the Durbin Amendment on Merchants: A Survey Study, 100 (3) Econ Quar. (Fed. Rsrv. Bank of Richmond) 183-208 (2014).
[5] Todd J. Zywicki, Geoffrey A. Manne, & Julian Morris, Price Controls on Payment Card Interchange Fees: The U.S. Experience, George Mason Law & Economics Research Paper No. 14-18 (2014); Geoffrey A. Manne, Julian Morris, & Todd J. Zywicki, Unreasonable and Disproportionate: How the Durbin Amendment Harms Poorer Americans and Small Businesses, Int’l. Ctr. Law & Econ. (Apr. 25, 2017), available at https://laweconcenter.org/wp-content/uploads/2017/08/icle-durbin_update_2017_final-1.pdf.
[6] 76 Fed. Reg. 43394 (Jul. 20, 2011), https://www.federalregister.gov/documents/2011/07/20/2011-16861/debit-card-interchange-fees-and-routing and specifically 76 Fed. Reg. 43466 (Jul. 20, 2011), available at https://www.govinfo.gov/content/pkg/FR-2011-07-20/pdf/2011-16861.pdf; Debit Card Interchange Fees and Routing (Regulation II), 12 C.F.R. § 235 (2011), https://www.ecfr.gov/current/title-12/part-235.
[7] Jean-Charles Rochet & Jean Tirole, Cooperation Among Competitors: Some Economics of Payment Card Associations, 33(4) RAND J. Econ. 549-570 (2002).
[8] Mark D. Manuszak & Krzysztof Wozniak, The Impact of Price Controls in Two-sided Markets: Evidence from US Debit Card Interchange Fee Regulation, Finance and Economics Discussion Series 2017-074, Fed. Rsrv. (Jul. 2017), https://www.federalreserve.gov/econres/feds/the-impact-of-price-controls-in-two-sided-markets-evidence-from-us-debit-card-interchange-fee-regulation.htm.
[9] Benjamin S. Kay, Mark D. Manuszak, & Cindy M. Vojtech, Bank Profitability and Debit Card Interchange Regulation: Bank Responses to the Durbin Amendment, Finance and Economics Discussion Series 2014-77, Fed. Rsrv. (Sep. 2014), https://www.federalreserve.gov/econres/feds/bank-profitability-and-debit-card-interchange-regulation-bank-responses-to-the-durbin-amendment.htm.
[10] Supra note 7 at 21.
[11] Id.
[12] Benjamin S. Kay, Mark D. Manuszak, & Cindy M. Vojtech, Competition and Complementarities In Retail Banking: Evidence from Debit Card Interchange Regulation, 34 J. Financ. Intermed. 91–108 (2018), at 104.
[13] Vladimir Mukharlyamov & Natasha Sarin, Price Regulation in Two-Sided Markets: Empirical Evidence from Debit Cards, SSRN (Nov. 24, 2022), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3328579.
[14] Supra note 3.
[15] 12 C.F.R. § 235.1
[16] Regulation II (Debit Card Interchange Fees and Routing), Fed. Rsrv., https://www.federalreserve.gov/paymentsystems/regii-data-collections.htm; Consumer Price Index: All Items for the United States, Fed. Rsrv. Bank of St. Louis, https://fred.stlouisfed.org/series/USACPIALLMINMEI (last visited Aug. 10, 2022).
[17] Wang et al., supra note 4. Some merchants saw their acceptance costs increase because—prior to Dodd-Frank’s price controls—some merchants, especially smaller merchants, had received discounts on acceptance costs. But the imposition of price ceilings also effectively created a price floor, leading some merchants to pay higher fees than previously.
[18] Supra note 13.
[19] Id. at 4.
[20] Manne, Zywicki, & Morris, supra note 5.
[21] Id. at 30.
[22] Id. at 30-31.
[23] Robin A. Prager, Mark D. Manuszak, Elizabeth K. Kiser, & Ron Borzekowski, Interchange Fees and Payment Card Networks: Economics, Industry Developments, and Policy Issues, Finance and Economics Discussion Series 2009-23, Fed. Rsrv. (Jun. 2009), available at https://www.federalreserve.gov/pubs/feds/2009/200923/200923pap.pdf.
TOTM In a recent guest essay for The New York Times, Aaron Klein of the Brookings Institution claims that the merger between Capital One and Discover would “keep intact the . . .
In a recent guest essay for The New York Times, Aaron Klein of the Brookings Institution claims that the merger between Capital One and Discover would “keep intact the broken and predatory system in which credit card companies profit handsomely by rewarding our richest Americans and advantaging the biggest corporations.”
That’s quite an indictment! Fortunately, Klein also offers solutions. Phew!
TOTM Capital One Financial announced plans late last month to acquire Discover Financial Services in a $35.3 billion deal that would give Capital One its own credit-card payment . . .
Capital One Financial announced plans late last month to acquire Discover Financial Services in a $35.3 billion deal that would give Capital One its own credit-card payment network, while simultaneously allowing the company to expand its deposit base, credit-card offerings, and rewards programs.
TOTM In yet another example of interagency cheerleading from the Federal Trade Commission (FTC), Chair Lina Khan recently touted the work of the Consumer Financial Protection . . .
In yet another example of interagency cheerleading from the Federal Trade Commission (FTC), Chair Lina Khan recently touted the work of the Consumer Financial Protection Bureau (CFPB) on payments networks:
https://twitter.com/linakhanFTC/status/1759962157133726060?s=20
Popular Media The credit card you used to purchase your latte this morning and to fill your car with gas was probably issued by a bank based . . .
The credit card you used to purchase your latte this morning and to fill your car with gas was probably issued by a bank based in Delaware, South Dakota or some state other than Colorado. Why? Because under a unanimous 1978 decision authored by liberal lion William Brennan, the Supreme Court ruled that banks holding a “national charter” would be governed by the interest rate ceilings of the state in which the bank is based instead of the state of the customer’s residence. This one decision transformed the American economy, unleashing unprecedented competition and putting Visa, Mastercard and other credit cards in the hands of millions of American families who were previously reliant on pawnbrokers, personal finance companies and store credit to make ends meet.
Yet a law set to go into effect in Colorado in July would deprive the most credit-deprived Coloradans of the same access to competitive financial services available to the more well-off and effectively destroy the rapidly growing fintech industry in the state. The consequences to Colorado’s more financially strapped households could be catastrophic. Other states are considering following suit.
