The Fed Bails Out the Banks...Again

If anyone doubted who set the marching tune for the Federal Reserve Board, it was sure clear today. The Fed announced its final rule under the Durbin Interchange Amendment, and it was quite the handout to the big banks.  

The Durbin Amendment instructed the Fed to pass rules that clarified its instruction that debit interchange fees must be reasonable and proportional to the incremental cost of authorizing, clearing, and settling an individual debit card transaction.  The Fed came out with a proposed rule last December that solicited comments on two alternative safe harbors.  One was for a flat fee of 7 cents per transaction, the other for 12 cents per transaction. The Fed also solicited comments on whether debit cards should have to be routable on 2 unaffiliated networks or on 2 unaffiliated PIN and 2 unaffiliated signature debit networks (4 networks total). 

Well, today the Fed came out with the final rule, and what a surprise.  

Instead of picking between the 7 or 12 cent safeharbors, the Fed now has adopted a 21 cent plus 5 basis points on transaction volume safe harbor.  So the Fed tripled the safeharbor!  This is nicely described by the Fed as "a variant of the [12 cent safeharbor] approach".  Is the variation to reverse the digits? That seems more like something out of the Goldberg Variations than a rational approach to regulation.  

What makes the 21 cents plus 5bp safeharbor even more outrageous is that there are already debit card interchange rates that are lower than that! Grocery and quick serve restaurants often have flat fee debit interchange rates of 19 cents.  If debit networks can do the transaction already for 19 cents, shouldn't that be the maximium possible safeharbor? And what about the Fed's findings that the median cost was 11 cents and the 80th percentile was 19 cents? 

If you want to understand the f.u. attitude from the Fed, take a look at footnote 105 in the final rule. It states that:

Several merchant commenters referenced a 2004 industry study (STAR CHEK Direct Product Overview study; First Annapolis Consulting) that found the per-transaction costs to be 0.33 cents for PIN debit and 1.36 cents for signature debit, but the study was not provided with the comments.

And the mighty Fed couldn't be bothered to go find the damn study? It's not hard to call up STAR or First Annapolis--I'm sure they'd provide it gratis to the Fed. 

Then there's the ad valorem component of 5 bps. The Fed explains it as:

The ad valorem amount is 5 basis points of the transaction’s value, which corresponds to the average per-transaction fraud losses of the median issuer.

There are three problems with this.  First, there is absolutely nothing in the statute that permits the Fed to include fraud losses as part of the "reasonable and proportional" calculation. Instead, the Fed is only permitted to include "the incremental cost incurred by an issuer for the role of the issuer in the authorization, clearance, or settlement of a particular electronic debit transaction." The fraud loss is not part of the cost incremental or otherwise of ACS. It is a completely separate type of cost. This was the Federal Reserve just disregarding the statutory langugage to hand the banks a bone. 

Second, the inclusion of an ad valorem fee was basically an ambush of merchants and consumer groups.  The Fed noted laconically that "Most merchants objected to an ad valorem component," but there was never a major push from merchant or consumers groups on this issue because it seemed to be out of contemplation given the proposed rulemaking. I know I would have had a lot more to say in my comments to the Fed had I thought they were thinking of any ad valorem component. Finally, there is absolutely no difference in the cost of authorizing, clearing, and settling a debit transaction that is $20 versus $200 versus $2000.

I've had my misgivings about the reasonable and proportional part of the Durbin Amendment, but I think the routing exclusivity provision was a major step forward in creating a more competitive debit card market.  The Fed, however, decided that more competition isn't good for the banks and went with the routing exclusivity option that requires less, rather than more competition for debit card routing. 

There's a broader lesson about financial regulation here. The passage of the Durbin Amendment and then the defeat of the Tester-Corker bill to delay the Durbin Amendment's effective date showed that financial reform could take place over the objection of the big banks if there were a strong non-bank lobby involved (here, retailers). But that political balance only holds true in Congress. Once the regulatory implementation was handed over to the Fed, the banks were playing with a home court advantage.

The lesson here is that if we want serious regulation of banks, we can't trust it to be done by bank regulators. We've seen the Fed and the OCC time and time again bend over backwards to let the banks out of statutory requirements. We've seen this with inaction (HOEPA regs), with aggressive preemption (and OCC is back to its old tricks...).

And this isn't just in the realm of consumer finance. This is also in the safety and soundness area. I'm not talking about stretched interpretations of section 13(3) of the Federal Reserve Act. I'm talking about affiliate transaction rules and Prompt Corrective Action, cornerstones of the safety-and-soundness regime. Saule Omarova has a great paper that shows how the Fed granted affiliate transaction waivers like a drunken sailor during the financial crisis.  Those were rules that went back to 1932-33 as part of Glass-Steagal.  

And remember Prompt Corrective Action? That was a response to all of the Federal Home Loan Bank Board's screw ups during the S&L crisis (Who you say? There's a reason the FHLBB doesn't exist any more...). PCA is clear of a bunch of tripwires as you can get. The whole point was to make sure that the bank regulators regulated, not coddled. But Bernanke announced that he was suspending PCA for the banks during the financial crisis. Only after the stress tests cleared the big banks did PCA get applied to the small banks, and with a vengance. What a sorry state of the world we live in where the bank regulators are the last people we can trust to actually regulate the banks.