Since the passage of the Dodd-Frank Act in July 2010, which required the Federal Reserve Board to establish standards for determining whether debit interchange fees are “reasonable and proportional” to the cost of the transaction, one argument in favor of this section of the legislation has been that debit cards are essentially “plastic checks.” Many merchants, in particular, have suggested that the swipe of a debit card should translate to a par payment like paper checks.
To understand the reasonableness of this assertion, it’s helpful to explore the development of the check platform that began during the national banking era (from the Civil War to World War I). Over this more than 50-year period, checks emerged as a more efficient payment medium than bank notes and drafts. Initially, checks could clear at either par or par less an exchange fee, the latter a precursor to what is called an “interchange fee” today. Rules associated with exchange fees were not standard in the late 19th and early 20th centuries, and the imposition of a fee could depend on whether local banks had agreements in place to clear each others’ checks at par.
As railroads expanded and regional commerce increased, check clearing at par became more problematic. Checks drawn on distant banks cost more to clear and were riskier. Critics at the time claimed exchange fees were “excessive” and even “monopolistic” on the part of banks. Common law, however, provided that check cashers could receive face value if they presented the check in-person at the check payer’s bank, thus creating a market distortion that led to less-than-optimal pricing.
In 1915, the Federal Reserve entered the check clearing business partly in response to the concerns over not-at-par banking. The Fed set up a national system for check clearing and mandated check collection at par. At first, thousands of banks resisted, but over time, their numbers dwindled.
Up until 1980, the Fed shouldered the cost of this national check-clearing platform. In 1980, however, Congress passed the Depository Institutions Deregulation and Monetary Control Act. One feature of this legislation required the Fed to charge banks fees to recover its check processing costs and price its services to be more competitive with the private sector. Banks absorbed the Fed’s new fees, and par checking, now firmly entrenched in society, continued.
Today, the volume of check usage has declined dramatically, while use of debit cards has exploded. Payment card networks have emerged and, like the early days of paper checks with exchange fees, interchange fees are seen by banks and card networks as necessary charges that enhance infrastructure investment and processing of electronic payments by the private sector.
For today’s banking industry, interchange fees have become an increasingly important source of income in the face of ever-shrinking revenue streams. The Federal Reserve Board estimates that approximately $11 billion of industry revenue is sourced to debit card interchange and another $5 billion of debit interchanges goes to support card networks annually. The profits generated by banks have, in turn, made interchange fees a source of contention with merchants. And while it’s true that merchants today bear the direct costs of these fees, it is likely that some portion of the interchange fee finds its way into the price of goods and services consumers purchase, regardless of their chosen payment mechanism.
A modern, well-functioning payment system network is not cost free. The bearer of costs will play out as the Federal Reserve’s debit interchange rulemaking moves toward completion and subsequent market adjustments occur.