Is the Credit Card Competition Act Good for Anybody?

Hey everybody, and welcome back to another episode of What's Going On in Banking. I'm your host, Ron Shevlin, chief research officer at Cornerstone Advisors and author of the FinTech Snark Tank blog on Forbes.

Today, we're going to look at the Credit Card Competition Act of 2023. There's a new bill in front of Congress that would, according to its sponsors, increase competition in the payments space by enabling merchants to select payment networks other than Visa and Mastercard at the point of transaction.

The benefit to merchants would be lower interchange fees, and the purported benefit to consumers would be lower prices as merchants pass those savings on to us. The real impact, however, could be just the opposite.

Todd Zywicki, a professor at George Mason University, wrote that by artificially pushing down interchange fees on credit cards, the bill would curb an important revenue stream for banks. Larger banks could offset those losses by selling investment advice, mortgages, and other products, or by imposing new fees as they did in response to the first Durbin Amendment, which affected debit cards.

Small banks, however, lack those revenue streams and would have to raise fees, curtail services, or merge, fueling industry consolidation.

Personally, and this is Ron Shevlin talking now, I find it ironic that politicians who want to see large banks broken up would propose financial regulations that could ultimately make them larger.

Consumers are the big losers here. They stand to lose many of the rewards they currently get on their credit card spending, and the idea that merchants would automatically pass savings on to consumers is questionable. Numerous studies have shown that merchants did not pass on savings after the original Durbin Amendment reduced debit card interchange rates.

Consumers could also find themselves on the losing end of an increase in fraud. In a new Cornerstone Advisors report titled The True Impact of Interchange Regulation, author Glenn Grossman pointed out that Visa and Mastercard offer consumers zero liability when transactions are processed on their networks.

A change to that format, however, would create a more fragmented fraud landscape. The guarantee of zero liability becomes less certain because consumers may not know whether their card brand processed the transaction or whether it was routed through an alternative network.

The proponents of the proposed regulation may also be overlooking the potential negative impact on merchants. As a result of the regulation, issuers could increase fees and tighten underwriting and credit standards. That could lead to lower spending and reduced revenue for merchants.

To help me make sense of all of this, I want to bring in today's guest. I probably shouldn't say this, but I'm going to be honest here: my guest was not my first choice. My first choice was Dick Durbin, but wisely, his office declined to participate. That actually worked out for the better because I wanted to bring in someone even more qualified to talk about this.

Michelle is a partner and co-founder at the Claros Group. I believe the company is headquartered in Washington, although you may be based on the West Coast. Is that correct?

We're 100% remote, so our company is wherever its partners are, which includes Washington and San Francisco.

Michelle's resume and credentials for talking about this topic are spectacular. She and her co-founders launched Claros Group about three and a half years ago. Prior to that, Michelle spent several years at Promontory Group and, before that, a good chunk of her career at the OCC.

Michelle, you were very involved in the original Durbin Amendment, weren't you?

Yes, actually. But I do need to correct you. I'm part of a group of founders of Claros. There are more than just two of us.

For a long time, I was a lawyer in the legislative and regulatory shop at the OCC. As part of that work, I led a number of interagency rulemaking efforts after Dodd-Frank. The Durbin Amendment really stands out in my memory for a few reasons that I'll get into in a moment.

I love talking about Durbin because the Durbin Amendment is a textbook example of unintended consequences. I hope law school classes are taught on these kinds of unintended consequences.

To clarify, the Durbin Amendment directed only the Fed to adopt implementing rules. The Fed consulted with the other banking agencies in preparing those rules, and it was wonderful to be included. I had a role in that consultative process that I really enjoyed.

Would you like me to review Durbin 1.0?

We can go back to that, but let's focus on the new act. I'd like you to focus first on the intended consequences, including lower rates. Do you believe that's going to happen and that consumers will see the benefits? Then please expand beyond that and tell me what you think the unintended consequences could be.

Okay, I'll give that a whirl. Do I think consumers will benefit from lower costs? No. Heck no.

As I said a moment ago, during the consultation process on the Durbin Amendment rules with the Fed, the staff of the banking agencies was extremely skeptical that the promised lower costs at Target would ever pan out. That just isn't generally what happens in retail, at least in my experience. Prices tend to go up.

There was a hoped-for outcome that if you lowered these costs, consumers would benefit. That was not the case. So I take a similarly dubious view of the claim that Durbin 2.0 would produce a result that simply did not materialize under Durbin 1.0.

Tell me what you think some of the further unintended consequences will be.

The really interesting thing about Durbin 1.0 was not only that the intended consequences failed to materialize. There were also unintended consequences. Your report goes into this in depth, and it's a heavily studied phenomenon.

Consumer costs went up. Issuers, including exempt issuers, saw their costs increase. Overall, maybe disaster is too strong a word, but it certainly was not a success in my view.

Here's the most interesting thing that happened with the Durbin Amendment. In 2010 and 2011, nobody was asking whether an entirely new industry would emerge as a result of it.

We weren't thinking about fintechs. We weren't thinking about neobanks that would exploit the exemption in the Durbin Amendment for small issuers. Ever since then, whenever I look at a new bill, I ask: what aren't they thinking about?

What clever and enterprising group or person might figure out a way around this requirement or through it? In saying that, I don't mean it as a criticism of fintech. Fintech is driving a number of valuable solutions for banks and their customers.

The point is that we did not anticipate it, and it helped give rise to a huge industry.

Durbin 2.0 would apply only to banks over $100 billion, so very large banks. Ron, I'd like to turn it back to you. Why do you think the intended consequence of exempting small issuers from this requirement won't pan out?

First, there's a fraud aspect. As I mentioned in the introduction, because of the difficulty in tracking transactions and the lack of a single view of the transaction, there could be a fraud impact as well.

Interestingly, I've talked to a number of credit union CEOs who think this could potentially benefit them because they're below the exemption level.

But going back to Zywicki's point, large banks have marketing budgets that dwarf what smaller institutions can spend. They will find ways to work around the downside from an interchange perspective. It's simply a margin decision.

Just as they did with Durbin 1.0, they'll start doing one-to-one negotiations because they have the power and the clout. I still think this has a net negative impact on smaller institutions because they lack that flexibility, and then there's the increased potential for fraud.

I also see other possible unintended consequences. If credit limits are reduced and spending declines, sales tax revenues go down by definition. Certain municipalities and governments could then be negatively affected by lower tax revenue.

The second- and third-order implications of this seem to be largely overlooked by the government and by the sponsors of the bill.

Let me get to the core of the issue. If you were writing the regulations, what would you write? More importantly, what is the fundamental problem that you think regulation should be trying to solve?

Durbin and the supporters of this bill say it's about increasing competition. I understand that Visa and Mastercard form a duopoly, but is that really the problem? Is this regulation actually solving it?

You've unleashed the beast a little bit here because you just asked a former regulation writer that question. I really enjoy this topic, but it is technical and bureaucratic.

If Durbin 2.0 is enacted, which I think is unlikely in the coming session, the Board will once again be charged with preparing implementing regulations.

Agencies generally have two options when writing implementing regulations, especially if staff and principals think the statute itself is misguided.

The first is to stick as closely as possible to the statutory language and write a preamble that essentially says our discretion is limited. In other words, not our fault. That's the easy way out.

The other option is to get creative. Agency staff can be very creative, and the Board staff includes very strong lawyers and substantive experts at the Fed. I would expect creativity to come into play.

Let me give you an example from Durbin 1.0. As people may recall, Durbin 1.0 directed the Board to limit interchange fees to an amount reasonably correlated with the actual cost of the transaction. Ultimately, the fee came out to around 21 cents.

The OCC submitted a letter to the Board at the time, when John Walsh was acting comptroller, arguing that the Board was taking too narrow a view of the cost components that should be considered.

I was involved in preparing that letter. The result was that I and a couple of other people were called up to Durbin's office for a scolding. But so what?

The Fed could again say that it needs to be mindful of consumer costs. It could impose a requirement for subsequent evaluation of the impact of the rules. That's possible.

It could also get creative with the Regulatory Flexibility Act, or RFA. The Board could complete an initial regulatory flexibility analysis with very pointed questions about the impact the regulation would have on a substantial number of small entities.

I realize this sounds technical and boring, but this is the sausage-making. Once a statute leaves the Hill, regulators have room to maneuver.

Depending on the comments on the initial RFA, the Board could ultimately determine that the rule may have a significant impact on a substantial number of small entities. That, in turn, can trigger periodic review and create a process for continually revisiting the rule and asking for additional comments.

That's a long-term and technical approach, but there are options.

So what would I do? I would be informed by the results of Durbin 1.0. As you said, it did not produce lower retail costs. Instead, issuer costs increased across the board, including for small issuers. Those costs were passed on to customers through higher monthly fees, minimum balance requirements, and similar charges.

It also helped create an entirely new fintech industry around the exemptions.

I would look for opportunities in the regulation to require impacted entities to demonstrate the rule's effects. I would also try to think ahead about how it might affect small banks and what, beyond simply exempting them, could be done to protect them.

What would you do, Ron?

I'd throw the damn thing out. It's ridiculous.

The Board can't do that.

No, the Board can't do that. But I would love to see the act fail before it gets enacted at all, with some actual forethought about the core problem it's supposed to solve.

I don't think there's a lot of proof that this approach is necessary. As an economy and a society, we love the small guy. We love to see companies become successful, and then when they get big, we hate them.

The reality is that there is a role for large institutions. If you're a mega corporation, you probably don't want to do all your banking with a $25 billion bank. There is value in having a JPMorgan Chase or Bank of America with the resources to support you.

The same evolution has happened in payments with Mastercard and Visa. Yes, they may have a duopoly, but that ignores the reality that American Express and Discover are also out there, along with other providers issuers can choose to work with.

We have an economy built around competition. The better competitor wins. That's different from directing outcomes through government mandate, especially when the potential negative implications include fraud.

And I think, Michelle, fraud is the real overlooked issue here. This is not primarily about whether Mastercard or Visa can absorb a hit. They can.

We're in an environment where fraud is rampant, especially because of the shift toward digital payments. This could exacerbate that problem.

Thankfully, there are consortiums such as Early Warning and new efforts taking shape. Sardine, for example, has created SardineX to bring smaller institutions together in more of a fraud consortium. Alloy Labs may also be doing work in that area.

But it is difficult to stay ahead of fraudulent actors. To me, that is one of the strongest arguments against mandating new routing requirements for transactions.

If merchants have a problem with interchange or their cost structure, they should also look elsewhere in their businesses for efficiencies. The old adage says half of your advertising is ineffective, so figure out which half. Large merchants spend tens of billions of dollars on advertising. Cut some of that, improve the bottom line, and pass those savings on to consumers.

I call this the "rent is too damn high" approach to banking regulation. It's essentially: we don't like big banks, we don't like Visa and Mastercard, we don't like bank executives who are fat cats and get paid too much.

There's a lack of nuance and a tendency to look for a boogeyman.

In this case, I believe Durbin is favoring the retailers. It's a giveaway to retailers. I'm not going to shed tears over the impact on Visa and Mastercard, and neither are you. I simply don't think there's demonstrated efficacy in this approach.

So if your question is what I would do if I were writing the regulations, that's one answer. If your question is what I would do if I were working on the statute itself, I would tank it. But nobody elected me.

All right, Michelle, last question. We're having this discussion now, but anyone watching will see it at least 48 hours after we're recording. Literally two hours before we got on this call, I saw a news alert that this may actually come to a vote in about 96 hours, maybe another 24 beyond that.

It's possible we may get this live before the vote, and it's also possible we won't. So I'm going to put you on the hook here. Is this going to pass?

No.

Okay. I agree with you, and I hope it doesn't. My prediction is that getting anything through the House is pretty difficult in this environment. That said, the bill does have some bipartisan support.

Yes, but as I said, everybody has their boogeyman, and not everybody in the House thinks Visa and Mastercard are it.

Great. Michelle, thank you so much for being on What's Going On in Banking. And to everybody who joined us, thank you very much for listening. I look forward to seeing you on another episode.

Thanks for having me.

Anytime, Michelle. Thank you.