I’ll Be Paying With Cash, Thanks

Robin Sidel and Dan Fitzpatrick at WSJ:

Bank of America Corp. and other banks are preparing new fees on basic banking services as they try to replace revenue lost to regulatory rules, in a push that is expected to spell an end to free checking accounts for many Americans.

Free checking accounts, which have been widely available for more than a decade, have been a boon to middle-class consumers and attracted low-income customers to the banking system for the first time.

Customers will likely be required to pay new monthly maintenance fees on the most basic accounts that don’t generate a lot of activity. To avoid a fee, customers will have to maintain certain account balances or frequently use other banking services, such as credit and debit cards, automated teller machines and online accounts.

“If you put $1,000 in a checking account and don’t do anything with it, it will be hard to get that for free,” says Sherief Meleis, a managing director at Novantas LLC, a consulting firm that advises banks.

Felix Salmon:

Why do most people hate their bank? Because their relationship is based on the lie of “free checking”, and a relationship based on a lie is always going to be a dysfunctional relationship. Checking is never free, but in recent years banks have been able to conjure the illusion of free through a system of regressive cross-subsidies, where the poor pay massive overdraft fees and thereby allow the rich to pay nothing.Interchange fees are a cross-subsidy too: this time it’s merchants who help pay for the checking accounts of the rich. In fact, they do more than pay for their checking accounts, they pay them a nice tax-free income, when the rich people accept debit rewards cards.

With the federal government finally cracking down on overdraft fees, and with the Durbin amendment threatening interchange fees to boot, the fiction of free checking looks as though it’s reaching the end of its natural life:

More than half of all checking accounts are currently unprofitable, according to a report issued last month by Celent, a unit of Marsh & McLennan Cos. It costs most banks between $250 and $300 a year to maintain one of the roughly 200 million checking accounts, according to industry estimates.

Checking accounts pay zero interest these days, but even being able to borrow money for free from depositors isn’t worth $300 per year to a bank. If a checking account has $1,000 in it on average, and the bank can lend that money out at 7%, net of defaults, then it’s making $70 a year on the account, which isn’t enough to cover its costs.

The natural answer, here, is to restart charging monthly fees on modest-balance checking accounts — and to shed few tears when your low-balance customers leave:

The offers of free checking without any minimum balance requirements attracted a new wave of low-income customers, who previously went to check-cashing stores. Some consumer advocates have warned that the elimination of free checking could drive some of those customers out of the banking system.

From the banks’ perspective, though, many of those customers aren’t profitable.

All of which provides some important background in understanding the stance of Patrick Adams, the CEO of St Louis Community Credit Union. Adams’s customers are relatively poor: his credit union is designated a Community Development Financial Institution, which targets the African-American community in St Louis. And he’s dead-set against any regulation of interchange fees, which provide an important source of income for his institution; he’s written three blogs on the subject, here, here, and here.

Adams, unlike Harriet May, was willing to provide me with concrete numbers:

We have 25,000 debit card holders with a 50/50 split on debit vs signature. We had 3.2 million debit card transactions in 2009 totaling $892,490 in debit interchange income or an average per transaction of just under 28 cents per. At an average interchange rate of 1.3%, our average member debit transaction is for 21.40. Our all in expense (including fraud) is $521,000.

We project that a 50% reduction in interchange would cost us $446,000 of top-line revenue. Something has to give if we lose that revenue. A $20 per year annual fee works, but we don’t want to fee our members.

Essentially, St Louis Community CU is getting about $35 of top-line revenue per year, per debit card. If that revenue disappears, it hurts the credit union’s finances. And so Adams is railing against interchange regulation:

Here’s another surefire lock of a bet. You will be more frustrated than ever. Your costs at the bank will be up. Your costs at the retailer will be up. You will be confused as to which retailers accept your debit card and which ones don’t. You will have no clue what the minimums and maximums of your debit card activity will be because there will be no consistency among retailers.

As a result, you will carry more cash and more checks… And, what about this double-dip possibility? You’ll use more checks at the check-out counter and the retailer will charge you a processing fee for doing it. (See, their handling of checks and cash are more expensive than debit cards.) You’ll pay for that, as well.

If this legislation is passed, I will mark my calendar to re-visit this issue a year after enactment. If I am wrong, I will eat the biggest piece of humble pie ever, including a public apology to everyone – starting with Senator Durbin. I must tell you that I’m extremely confident that an apology won’t be forthcoming.

I’ll take Adams’s bet. Yes, the costs of a checking account will be more transparent and visible to consumers. But costs at the retailer will not rise, since the retailer’s costs will have fallen. There will be no confusion about which retailers accept which debit cards, and debit-card minimums and maximums will be a non-issue. People will not carry more cash, and they certainly won’t carry more checks. And Adams will owe a public apology to Durbin.

Stephen Spruiell at The Corner:

The old model: Banks use high fees on avoidable behaviors that are nevertheless common among the financially inept, such as account overdrafts, to subsidize free checking accounts and other reward programs for customers who use their accounts responsibly.

The new model: Liberals argue that overdraft fees are abusive and should be banned. Democrats enact new restrictions on overdraft fees. Banks end free checking accounts and other reward programs for responsible customers.

And we haven’t seen anything yet. Just wait until the new Consumer Financial Protection Bureau gets to work.

Matt Welch at Reason:

It was just terrible that the fine print of free-checking accounts included language saying “We will charge you for overdrafting your account, loser,” a sad fact easily divined by, for instance, overdrafting your account. So, consumer advocates, noble regulators, and other champions of the little guy came up with a genius solution: require banks to obtain letters from customers saying “Please charge me a lot of money when I write a bad check.” The result?

Bank of America Corp. and other banks are preparing new fees on basic banking services as they try to replace revenue lost to regulatory rules, in a push that is expected to spell an end to free checking accounts for many Americans.

Hooray for progress! Back to the mattress!

Kevin Drum:

This is fundamentally my problem with overdraft and interchange fees: they’re basically surreptitious ways for the poor to subsidize the rich. There’s no law against that, of course, but the practice is so grotesque that in this case I’m perfectly willing to make one.

Basically, what banks have learned is this: it’s mostly poor people who pay overdraft fees. That makes sense, of course: they’re the ones most likely to run out of money, aren’t they? The thing is, it’s easy to fool unsophisticated consumers into not noticing these fees, or into thinking that they’ll never have to take advantage of them. But banks know better. They know to three decimal places how often low-income customers are likely to screw up slightly and overdraw their account by twenty bucks. And when they do, they’re charged obscenely more than the actual cost of servicing the overdraft. So who benefits? I do. I always have plenty of money in my checking account and I’ve never overdrawn it. So the entire debit card system is, for me, free.

The same is true for interchange fees. Banks charge merchants far more in interchange fees than it costs to actually run their payment networks, and merchants pay because they have no choice. Visa and Mastercard are functional monopolies, so if you want to do business with them — and what merchant can afford not to? — you have to pay whatever they tell you to pay. This cost gets passed on to consumers, of course, and the poor and working class pay it. The middle class and the rich, however, don’t: they basically get the fees rebated in the form of reward cards.

So you have two cases here of a system that costs money to operate, and in which the costs are largely borne by the poor in order to make them free (or cheap) to the better off. If you can sleep easily at night even after you understand how this works, you have a heart of stone.

So what’s the alternative? Simple: fees that are fair and transparent. Overdraft fees should cover the average actual cost of overdrafts plus a small amount. Interchange fees should cover the actual cost of operating an electronic payment network. Credit card interest rates should cover the risk-adjusted cost of actually loaning out money.

And to those interchanges, Reihan Salam in Forbes:

As trousers grow skinnier, our mobile phones are following suit, as evidenced by the ultraslim iPhone 4. But the U.S. Treasury, alas, has no intention of altering the design of its coins to accommodate America’s evolving fashion sense. At home my coins accumulate in jars and paper cups and drawers, perhaps to serve as raw material for some future magnetic art project. And as for bills, I only use them when absolutely necessary.

Generally speaking merchants will accept debit cards for even very small transactions. But as we all know, they don’t like it. In New York City, where cab drivers are required to accept electronic payment, many drivers will plead with you to use cash, citing the onerous fees collected by the banks.

These swipe or interchange fees are the target of a new regulation proposed by Sen. Dick Durbin of Illinois, a liberal stalwart keen to pick a fight with the financial sector. Merchants have been urging Congress to take action on swipe fees for years, but it’s only now, when esteem for the financial sector is at a low ebb, that there’s been any hope of a tough regulatory response.

My gut instinct is to distrust sweeping regulatory efforts. When the interests of one set of businesses are pitted against another set of businesses, I’m inclined to let consumers decide who should come out ahead. Yet swipe fees pose a number of interesting puzzles.

In January Andrew Martin of The New York Times published a scathing exposé of how Visa and MasterCard squeeze retailers. The two big payment networks dominate the marketplace by making their offerings attractive to banks and credit unions that, in turn, issue debit and credit cards. Visa and MasterCard set fees for every debit card transaction, fees which vary by type of card, among other things. But the banks collect the fees and, all other things being equal, they like making more money rather than less.

Visa and MasterCard are serving their customers extremely well. The trouble is that their customers are banks–not consumers, who face higher prices as merchants pass on higher fees in the form of higher prices. Indeed Visa was, according to Martin, the first to pursue the high-fee strategy. MasterCard found that it was losing market share to Visa by continuing to offer lower fees, and so it quickly matched its rival. It’s hard to see how Visa and MasterCard might break out of this very stable dynamic; last fall the Government Accountability Office issued a report describing how swipe fees have steadily increased.

One argument, raised by scholars Todd Zywicki and Geoffrey Manne, is that swipe fees are a way to pass on credit losses to merchants. Yet as financial blogger Felix Salmon of Reuters observes, merchants don’t also benefit from the much larger credit profits derived from fees and interest payments enjoyed by banks.

Swipe fees could be increasing due to rising levels of fraud and identity theft. That, however, would represent a case for shifting away from signature debit and towards PIN credit. But signature debit is more profitable for card issuers, which is presumably why there hasn’t been aggressive movement in this direction. In Salmon’s view, rising swipe fees represent pure rents for the effective duopoly of Visa and MasterCard, and the Durbin amendment would help shift the balance of power towards merchants and consumers.

The case for regulation does seem fairly strong. To me that suggests that there’s been a serious failure on the part of entrepreneurs. One wonders how the Visa-MasterCard duopoly has become so robust. In the absence of new swipe fee regulations, it’s possible that merchants will band together to find a superior alternative. The trouble is that the retail sector remains fairly fragmented, and cooperation on this scale would be very difficult to achieve. The past decade has seen a number of innovative payment systems emerge, from PayPal to Square.

Mike Konczal at Rortybomb:

Remember this debate is about reward cards versus debit cards. Merchants love debit cards, they are easier than cash. They don’t want to subsidize the airline industry by having to pay for rich people’s frequent flyer miles reward card for free, without anything in exchange for providing an additional good or service.

But they can’t give incentives for debit cards under current law. They can’t offer you a free loaf of bread with your groceries for typing in your pin, or give you your very own pin express checkout lane, for using debit. That is valuable local information and retail innovation that is lost. So watch for interchange rates being juked between high rewards credit cards, generic credit cards, the abomination that is “signature debit”, and pin debit.

I am not certain whether or not Hill staffers are currently being bombarded with financial lobbyists with vested interests claiming all kinds of decreases in interchange over the past decade. This data is very hard to find, as the credit card companies guard it vicious. Now, I’m just a dude with a matlab license and a free blog, so let me tell you what other credible people have researched and found recently.

Tim Lee at McArdle’s place:

Most of the commentary on interchange fees have focused on the rate paid by merchants, but this is the wrong number to focus on. Rather, we should care about the net of merchant fees minus cardholder benefits. If credit card fees rise but benefits rise by an equal amount, the result is a wash as far as the customer is concerned. I’m not aware of any precise data on cardholder benefits, but judging from the fact that companies used to charge an annual fee to issue credit cards and they now frequently offer generous cash back, I think it’s safe to say that benefits have gotten more generous over time. So looking only at interchange fees gives us a distorted picture.

Now maybe you don’t believe that banks will continue to pass increased fee revenues on to their customers. But notice that this is a symmetrical situation. If you doubt that competition among banks will shift most of the benefits of higher fees to consumers, then you should be equally skeptical of claims that competition among merchants will translate lower credit card fees into lower retail prices.

Konczal writes derisively about cardholder benefits, arguing that merchants “don’t want to subsidize the airline industry by having to pay for rich people’s frequent flyer miles reward card for free, without anything in exchange for providing an additional good or service.” But this misses the point in a couple of important ways. First, the benefits are limited neither to frequent flyer miles nor to rich people. But more fundamentally, what merchants want is irrelevant, because there’s no reason to think consumers’ interests are more aligned with merchants than with banks. Indeed, you could view the credit-card-issuing banks as agents for cardholders, negotiating for discounts that are passed along to their customers.

Advocates of regulation like to tell a populist story of consumers against rapacious banks. But there are wealthy corporations on both sides of the bank-merchant relationship. There’s no reason for regulators to side with Wal-Mart over Wells Fargo. Policymakers should focus on ensuring that both sides of the market (card-issuing banks and card-accepting merchants) are robustly competitive. Then consumers will reap most of the benefits whether interchange fees go up or down.

Konczal responds:

This argument is predicated on the idea that all people in the United States have access to the high-end consumer credit market. In general, the “two-sided markets” argument assumes a single representative consumer and a single representative business in a closed loop, where value can’t really be transfered in or out. That’s not the real world, where there are multiple payment systems, including cash, debit and credit cards with different prices, and multiple people with different access to credit.

Rich is a loaded term, but let’s throw some numbers out there. Here is an estimate that 13.2% of American households don’t own a checking account and about 9.5% of American households hold no bank account at all. They’ll pay the same price for goods and services as Tim, but not receive 1% back in cash. There’s a move to try and get the unbanked decent prepaid debit cards. They’ll definitely not get a good rewards problem out of it.

Is there inequality within the credit market for those who have access to it? From Adam Levitin’s Priceless? The Social Costs of Credit Card Merchant Restraints (19), which gives a history of the “merchant restraints” on distinguishing between debit and credit, we know that: “Visa Signature cards, which carry a high level of rewards and are marketed specifically to affluent consumers, comprise only 3.5% of all Visa cards but have accounted in recent quarters for 22.2% of all Visa purchases.” That’s a high volume of purchases with high rewards going to just a few people. Many people have rewards cards, but the very best ones are reserved for the high end, and those at the high end spend more than those not at the high-end. And everybody pays the same price.

We also know that around 45% of interchange goes to fund rewards. These high interchange rates drive up prices. Tim’s 1% back requires a merchant to pay an estimated 2.22% interchange for that feature alone. People who get less back, or who use debit, or who pay with cash, are paying higher prices to transfer money to Tim.

Want to get even more regressive? The people with poor access to high-end credit are paying higher prices to transfer tax-free income to Tim. Tax-free! It’s true many people have access to rewards cards, but some use them significantly more, and with much nicer, rewards than others. Those few are not scattered randomly among the population.

Tim Lee responds:

Mike Konczal has a sharp response to my post on interchange fees. He’s been following this issue more closely than me, so there’s a lot of good information there. But one part of his argument that doesn’t seem quite right is this:

Is there inequality within the credit market for those who have access to it? From Adam Levitin’s Priceless? The Social Costs of Credit Card Merchant Restraints (19), which gives a history of the “merchant restraints” on distinguishing between debit and credit, we know that: “Visa Signature cards, which carry a high level of rewards and are marketed specifically to affluent consumers, comprise only 3.5% of all Visa cards but have accounted in recent quarters for 22.2% of all Visa purchases.” That’s a high volume of purchases with high rewards going to just a few people. Many people have rewards cards, but the very best ones are reserved for the high end, and those at the high end spend more than those not at the high-end. And everybody pays the same price.

We also know that around 45% of interchange goes to fund rewards. These high interchange rates drive up prices. Tim’s 1% back requires a merchant to pay an estimated 2.22% interchange for that feature alone. People who get less back, or who use debit, or who pay with cash, are paying higher prices to transfer money to Tim.

I’m not sure I follow Mike’s math here. The fact that 44 percent of interchange fees get passed through as rewards doesn’t mean that a dollar of rewards “requires” a fee of $2.22. Offering a credit card at all costs money; you have to do things like printing statements, processing checks, staffing help lines, and the like. For less affluent customers, the revenue from interchange fees may barely cover these fixed costs, leaving little revenue for benefits. For more affluent customers, in contrast, the fixed costs will be a small fraction of interchange fee revenues, and so the company can afford generous benefits. This isn’t a transfer of wealth from poor to rich, it’s just a reflection of the fact that wealthier customers are more lucrative.

If regulatory measures push down interchange fees, it will likely mean that affluent customers get less generous benefits. But it may also mean that the least affluent credit card holders have to start paying annual fees again (or won’t get cards at all) because interchange revenues no longer cover the cost of providing the card. This isn’t an outcome we should cheer if we’re concerned about those at the margins of the banking system.

UPDATE: Katherine Magu-Ward at Megan McArdle’s place

Matthew Yglesias responds to Drum

Drum responds to Yglesias

UPDATE #2: More Drum

Yglesias responds to Drum

Megan McArdle

John Cole

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2 responses to “I’ll Be Paying With Cash, Thanks

  1. Pingback: What We’ve Built This Weekend « Around The Sphere

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