Federal Reserve Open Board Meeting, December 16, 2010

Uploaded by FedReserveBoard on 17.12.2010

CHAIRMAN BERNANKE: Good afternoon.
The purpose of today's meeting is to consider the staff's recommendation
that the Board request public comment
on a proposed rule implementing Section 1075 of the Dodd-Frank Act.
This provision of Dodd-Frank deals with the regulation of interchange fees
on debit cards and related matters.
U.S. financial regulatory agencies have been given significant new responsibilities
under Dodd-Frank.
In a number of cases, the law requires the Board and other agencies to address complex
and challenging issues within a short time frame.
This is certainly true with respect to this particular rulemaking.
Although it is important for us to act expeditiously, both to meet the requirements
of the law and to establish regulatory clarity as soon as possible, the proposal today is one
that deserves particularly careful attention from the Board,
in light of debit cards' increasingly important role in the U.S. payment system.
We have already gathered a great deal of information bearing on this rulemaking
from a variety of sources and we look forward to receiving the public's comments.
Let me now turn to Vice Chair Yellen, who leads the Board's Committee on Payments,
Clearing and Settlement, the committee which reviewed the staff's proposal.
VICE CHAIR YELLEN: Thank you, Mr. Chairman.
As you noted, this afternoon we will consider staff's proposal
for implementing the debit card interchange fee
and transaction routing provisions of the Dodd-Frank Act.
As background to this proposal, it is important
to note the prominent role debit cards now play in our payments system.
The results of a new Federal Reserve survey published earlier this month show
that nearly 38 billion debit card payments were made in the United States in 2009.
Debit cards are now used in 35% of noncash payment transactions.
They've eclipsed checks as the most frequently used noncash payment method.
The Dodd-Frank Act specifically directs the Board
to set standards for debit card interchange fees.
These fees are established by payment card networks and are paid by merchants
to card issuers for each debit card transaction.
Over time, interchange fees have grown as both the number of debit cards transactions
and the level of interchange fee rates have risen.
This has precipitated a national and international debate
over the appropriate level of the fees.
In 2009, debit card interchange fees totaled over $16 billion in the United States.
The Board's Payments, Clearing and Settlement Committee has discussed
with staff the numerous difficult issues involved in developing this proposed rule.
I believe staffs' proposal reflects a reasonable approach
to implementing these requirements of Dodd-Frank.
That said, we've included a number of questions in the Federal Register notice
about alternative approaches to implementing different parts of the rule.
We will be interested in reviewing commenters' input on the proposal
as we determine what refinements should be made when it's adopted as a final rule.
I'd like to now turn to Mark Manuszak, who will discuss the staff's proposal.
I will be discussing proposed new regulation II,
which would govern debit card interchange fees and routing.
This proposed regulation, which implements Section 1075
of the Dodd-Frank Act, has two main components.
First, it establishes standards for determining the maximum permissible level
of debit card interchange fees that issuers may receive.
Second, it prohibits network exclusivity arrangements and merchant routing restrictions.
Since enactment of the Act we have held numerous meetings with debit card issuers,
payment card networks, merchant acquirers, merchants, industry trade associations
and consumer groups to deepen our understanding of the debit card industry.
These organizations provided information about the structure and mechanics
of the debit card system, fraud losses and fraud mitigation activities
and fees associated with debit card transactions.
We also reviewed written submissions by interested parties that highlighted issues
to be considered in implementing the statute.
We have posted the meeting summaries and the written submissions on the Board's Web site.
To obtain further input, earlier this fall we surveyed covered debit card issuers,
payment card networks and large merchant acquirers.
We requested information about the volume, costs, fees, fraud losses
and fraud prevention activities associated with different types of debit card transactions.
We also asked about network exclusivity arrangements and routing restrictions.
The information gathered through these surveys has informed our development
of the proposal before you today.
Let me now turn to the substance of our recommended proposed rule.
I will summarize each major statutory requirement and then describe how we propose
to implement it, including alternative approaches we considered.
The first major aspect of the proposed rule is the interchange fee standards.
The statute requires that the amount of any interchange fee that an issuer receives
for a debit card transaction be reasonable and proportional
to the issuer's cost with respect to the transaction.
The Board is required to establish standards
for assessing whether an interchange fee meets the reasonable and proportional requirement.
The statute exempts certain issuers and cards from the restrictions on interchange fees.
These restrictions do not apply to issuers that together
with affiliates have assets of less than $10 billion.
The restrictions also do not apply to debit cards used
in certain government-administered payment programs
and certain reloadable general-use prepaid cards.
To implement this portion of the statute we determined which types
of issuer costs should be allowable and how best to measure those costs.
In determining which issuer costs should be allowable, we looked
to the two considerations Congress included in the statute for the interchange fee standard.
The first instructs the Board to consider the functional similarity
between debit card transactions and checks, which clear at par.
The second instructs the Board to consider the issuer's incremental cost to authorize,
clear and settle a particular transaction and not to consider costs
that are not specific to a particular transaction.
We recommend that an issuer's allowable costs be limited to those costs that are attributable
to the issuer's role in authorizing, clearing and settling a transaction.
This approach includes only those costs that are specifically mentioned in the statute.
We considered limiting the allowable cost to include only those costs associated
with authorizing a debit card transaction.
This approach would reflect a key distinction between debit card and check transactions:
the fact that a debit card transaction is authorized
by the issuer whereas a check transaction is not,
although merchants may purchase a third-party check guarantee service.
However, because the statute specifically instructs the Board to consider clearing
and settlement costs in addition to authorization costs,
we believe it is appropriate to include those costs rather
than limiting the definition to authorization costs only.
We also considered including other costs associated with a particular transaction
that are not associated with authorizing, clearing, and settling the transaction.
Such costs might include, for example, the cost of providing cardholder rewards and the cost
of responding to cardholder inquiries regarding specific transactions.
Given the statute's mandate to consider the functional similarities between debit card
and check transactions, however, we recommend that the Board propose to limit allowable costs
to those that the statute explicitly references for consideration.
As I mentioned earlier, the statute directs us
to consider the incremental cost of a particular transaction.
There's no single generally accepted definition of the term "incremental cost."
We propose to interpret the incremental cost as average variable cost.
This measure, which is relatively easy to calculate using cost-accounting data,
yields the cost of a typical, or average, transaction.
We also considered interpreting incremental cost as marginal cost but determined
that this approach would be impractical,
in part because marginal cost cannot be identified from cost-accounting data.
We know, however, that if marginal cost does not vary materially over the relevant volume range,
then average variable cost will provide a close approximation to marginal cost.
In measuring issuer cost we also considered the appropriate treatment
of fixed costs and common, or overhead, costs.
We recommend that fixed costs of debit card transactions be excluded
from the measurement of allowable costs.
The statute directs us to consider the costs of a particular transaction.
Fixed costs as well as common or overhead costs generally could not be avoided
by ceasing production of any particular transaction.
We recommend that the Board request comment on two alternative standards
for determining whether an interchange fee is reasonable
and proportional to the issuer's cost.
The first alternative adopts a standard based on each issuer's cost with a safe harbor and a cap.
The second alternative adopts a stand-alone cap that is applicable to all covered issuers.
Under alternative 1, an issuer would comply with the standard if it received an interchange fee
that did not exceed the lesser of its allowable average variable cost and a cap.
We recommend that the cap initially be set at 12 cents per transaction.
Alternative 1 would also permit an issuer to comply with the standard
by receiving an interchange fee that does not exceed the level of a safe harbor.
If the interchange fee is at or below the safe harbor, the issuer would not need
to determine its maximum interchange fee based on allowable costs.
We recommend that the safe harbor amount initially be set at 7 cents per transaction.
Under alternative 2, an issuer would comply with the interchange fee standard as long
as it does not receive an interchange fee above the cap.
Under this alternative we also recommend that the cap initially be set
at 12 cents per transaction. We believe that both alternatives provide economic incentives for covered issuers
to improve the efficiency of their card operations.
We also believe that the safe harbor in alternative 1 and the cap
in alternative 2 reduce the administrative compliance burden
on industry participants compared to a standard based solely on each issuer's costs.
The statute authorizes the Board to allow for an adjustment to an interchange fee to account
for an issuer's cost in preventing fraud, provided the issuer complies
with standards established by the Board relating to fraud prevention activities.
The proposed rule does not currently include a specific adjustment to the amount
of interchange fees for an issuer's fraud prevention costs.
Instead, we recommend that the Board request comment on two general approaches
and ask a number of questions related to those alternatives.
Under the first approach, the fraud adjustment would allow issuers to recover costs incurred
for implementing major innovations that would likely result in substantial reductions
in total industry-wide fraud losses.
Under the second approach, the fraud adjustment would reimburse the issuer
for reasonably necessary steps it takes to maintain a fraud protection program.
However, the Board would not prescribe specific technologies
that must be employed as part of the program.
After considering the comments we receive we will recommend
that the Board issue a specific proposal on the fraud adjustment for public comment.
The statute grants the Board authority to address circumvention
or evasion of the interchange fee standard.
Under the proposed rule a finding of circumvention
or evasion will generally depend on the facts and circumstances.
However, the proposed rule specifically provides that circumvention or evasion occurs
when an issuer receives compensation from a payment card network, for example,
in the form of incentive payments, that exceeds the total amount of fees
that the issuer pays to the network.
Under these circumstances, the net compensation from the network would effectively serve
as a transfer to an issuer in excess of the amount allowed
under the interchange fee standard.
We considered whether increases in network fees charged to merchants,
combined with corresponding decreases in fees charged to issuers,
should also be considered circumvention or evasion.
We decided against this approach because it would effectively lock
in each network's current allocations of fees between issuers and merchants
and would prohibit some payment card networks from changing their fee structures
to resemble those currently employed by other networks.
The proposal requests comment on whether this or other forms of circumvention
or evasion should be addressed in the rule.
In addition to rules related to interchange fees the statute requires the Board
to prescribe rules related to the routing of debit card transactions.
First, the Board must adopt rules that prohibit issuers and payment card networks
from restricting the number of networks on which a debit card transaction may be processed
to fewer than two unaffiliated networks.
Second, the Board must adopt rules that prohibit issuers and networks from inhibiting the ability
of merchants to route debit card transactions over any network
that may process such transactions.
Together these provisions are generally designed to give merchants a choice of networks
over which a debit card transaction may be routed.
These provisions will apply to all issuers, including small issuers
and certain prepaid card programs that are exempt from the interchange fee standards.
We recommend that the Board propose two alternatives for implementing the prohibition
on network exclusivity arrangements.
The first alternative, which closely tracks the statutory language, would require a debit card
to be able to be routed over at least two unaffiliated payment card networks.
An issuer could comply, for example, by having one signature network
and one unaffiliated PIN network on a card.
However, this approach may have limited effectiveness in promoting network competition.
About 6 million of the 8 million merchant locations in the United States
that accept debit cards currently do not have the capability to accept PIN debit transactions.
Moreover, there are currently operational or market impediments to using PIN debit
for certain types of transactions.
For transactions that cannot be conducted using PIN debit,
this alternative would not provide a viable routing choice to the merchant.
The second alternative would require a debit card to have
at least two unaffiliated payment card networks for each method
of authorization available to the cardholder.
For example, a debit card that can be used for both signature
and PIN debit transactions would need to have at least two unaffiliated signature debit networks
and two unaffiliated PIN debit networks.
This approach would better ensure merchant routing choice but would require issuers
to have multiple signature debit networks, such as Visa and MasterCard, on their cards,
unless a card had only PIN functionality.
Such a requirement would entail substantial operational changes by debit card networks,
issuers, merchants, merchant acquirers and their processors.
Greater merchant routing choice may promote market discipline and discourage networks
from setting high interchange fees or network fees.
The proposed rule prohibits issuers in networks from inhibiting merchant routing choice
and includes examples of issuer or network actions
that would impede merchant routing flexibility, such as issuer or network rules
that require routing of a transaction over a particular network
when multiple networks are available.
The statute requires the Board to establish final interchange fee standards as well
as rules prohibiting circumvention or evasion no later than April 21, 2011.
These rules take effect three months later on July 21.
The Board must issue final rules that prohibit network exclusivity arrangements
and routing restrictions no later than July 21, 2011,
but the statute does not establish an effective date for these rules.
The draft Federal Register notice requests comment on the lead time required
to implement the prohibitions on network exclusivity and routing restrictions.
The amount of lead time required will likely depend
on the approach the Board adopts in its final rule.
My colleagues and I would be happy to answer any questions you may have.
CHAIRMAN BERNANKE: Thank you very much.
This is a very complex issue, and I want to thank the staff for a great deal
of effort that's been put into this: a lot of person hours, a lot of outreach to the public,
a lot of analysis, so thank you for bringing us this proposal.
We have opportunity for some questions.
Let me start off. There's a presumption that prices will be set by market competition,
generally, but then, of course, there are counter-examples such as electric utilities,
for example, where government intervention can be justified for various reasons.
Can you help us think about why -- you know, what are the arguments for
and against allowing interchange fees to be determined in the market
versus having a regulatory intervention?
Give me -- think about the economics.
So, as you know, in most markets increased competition leads to lower prices.
However, in payment card markets competition between networks tends
to drive interchange fees higher, and the reason for this is that in these markets the party
that decides what method of payment will be used at the point of sale, that is, the customer,
is different from the party that incurred the cost associated
with that decision, the merchant.
And, in general, customers don't tend to take into account the costs incurred
by merchants as a result of their decisions.
The networks want banks to issue their cards and they want customers to hold and use their cards,
and they provide an incentive to the banks to issue cards by offering higher interchange fees.
The banks use the revenues from these interchange fees
to offer more attractive deposit account terms to their customers,
including in some cases rewards for making payments with debit cards.
Meanwhile, the merchants, who ultimately foot the bill for their customers' payment choices,
have little or no ability to influence the customer's decision
with regard to what payment method to use.
In addition, given the near ubiquity of card acceptance and the expectations of customers,
many merchants believe that they really don't have the option
of refusing to accept card payments.
So even though merchants would prefer lower interchange fees,
unless the fees are extremely high, they're likely to continue to accept cards,
and as a result competition in these markets tends to focus on the issuers
and the cardholders, who prefer higher interchange fees,
so the result of that competition is to drive those fees up rather than down.
Thank you.
I know this is an issue that other countries have looked at.
Have you reviewed the experience of other countries and your proposal, how does it compare
to what other countries have done in this area?
So, yes, staff has looked at various foreign models of interchange fee regulation,
including those of the Reserve Bank of Australia and the European Commission.
In Australia -- the Reserve Bank of Australia was given authority to regulate both credit card
and debit card interchange fees, and the RBA had broader latitude regarding how
to regulate interchange fees than the Board does have currently.
Nonetheless, it did use a cost-based criteria to arrive at their benchmark interchange fee,
which is for debit cards -- signature debit cards -- 12 cents.
In Europe the European Commission initiated an investigation of cross-border
or debit card interchange fees, and in recent settlements with Visa and MasterCard,
the European Commission used a very different criteria that was not based on issuer costs
but rather merchant benefits and costs.
From that approach they arrived at an average cross-border interchange fee of about .2%,
which corresponds to about 8 cents on a typical debit card transaction of about $40.
So despite some of the differences in the statutory authority and approaches,
the staff recommendation of 7 cents for the safe harbor and 12 cents
for the cap are not materially different
from what these other authorities have determined to be appropriate.
Thank you.
Vice Chair?
I can think of a number of different ways in which this rule could affect consumers,
and I wonder, have you thought through what the likely overall effect
of this rule is going to be on consumers?
So we think the affect of this rule on consumers is difficult to predict,
but we do have some observations.
Today merchants generally pass on the cost of debit card acceptance,
which includes interchange transaction fees to consumers through higher prices for their goods
and services because merchants generally don't distinguish
between various forms of payments in their pricing,
consumers that use cash or checks may pay more than if the cost
of card acceptance were not reflected in the price of goods or services.
So given reductions in interchange fees and in overall debit card acceptance cost,
merchants could choose to pass the savings through, which could benefit both the consumers
that primarily pay with cash or checks, as well as debit card users.
We expect this would be most likely to happen, that is,
lower costs would be most likely be passed on to consumers,
in those markets with lower margins and intense price competition.
However, any savings that consumers might realize at point of sale could be offset
by fee increases at their banks, as well as changes in terms that debit cardholders face
for card use and deposit accounts.
So specifically, account holders at covered institutions may face higher fees
for debit card use or additional account fees, and they could receive less favorable terms
for their deposit accounts and related services.
So, for example, one of the first things that interest may do is reduce
or eliminate debit card reward programs, and these changes that may happen
at the bank may be somewhat more visible to consumers than any savings
that they realize at the point in sale.
So overall, I think it's hard to anticipate what the overall effect on consumers will be.
I have just one other question.
You know, as I noted in my opening remarks, debit cards are growing
in importance as a means of payment.
Is it possible that this rule could affect the use of debit cards as a means of payment?
Is that something you anticipate?
Yes, it is something we have put some thought into, and as you noted in your opening remarks,
debit cards are an important method of payment in the U.S. today.
They provide a convenient way for consumers to make payments as well as to track
and control their spending, so we're very interested in the outcome in this way.
With regard to the proposed rule, the effects on debit card use overall will have differences,
depending on how consumers respond to the incentives that are provided
by either merchants, on the one hand, or card issuers on the other.
Merchants, because of the lower interchange fees and because of the ability to steer
or direct customers or encourage customers to use debit, will have the incentive both
to be more likely to accept debit cards and to steer customers in the direction of debit,
and this puts the market in the direction of greater use of debit cards overall.
On the other hand, issuers, because they'll see lower revenues from interchange fees
from debit transactions, will have more of an incentive to perhaps encourage their customers
to use other forms of payment or to back off on any existing rewards program of the debit cards.
So on the whole, we don't know what the outcome will be in the market.
Again, it will depend on how consumers respond to the incentives that they're facing.
GOVERNOR WARSH: So the statute --
the first reading of the statute says
that the Board shall establish standards for interchange fees.
It doesn't say we should establish prices.
So can you take us through why the staff proposal has us in the price-setting business?
Is it because that's what a fuller reading of the statute implies
or is that price setting will be more pro-competitive,
more useful for the industry with clearer rules?
Perhaps you can help us think through the rules on standards versus prices.
There were really two reasons why we decided to not just propose an issuer-specific standard
but put some actual values in the standard, and that is to avoid negative economic incentives
and to minimize administrative burden.
So if you think about an approach
where the standard just says you can get an interchange fee that is the same as your costs
for authorizing, clearing and settling a transaction, with no cap,
it would not provide incentives, we believe,
for issuers to have efficient operations and control their costs.
If they had very high cost operations, they would be able to recoup those costs
from the interchange fees, and if they implemented efficiency improvements
and reduced their costs, their interchange fees would go down commensurately.
And so that gave us some pause.
And if you think about the way that the safe harbor works in our first alternative
or the cap works in the second alternative, it gives some positive incentives
for issuers to reduce their costs.
If they can reduce their costs to below the safe harbor, they can reap the difference
between their actual costs and the safe harbor amount that they would be able to get.
In alternative 2 where it's just a cap, to the extent that they're below the cap,
they would be able to benefit from the difference in their cost and that cap.
The other thing we were thinking about is administrative compliance burden.
To the extent that in alternative 1 there's a safe harbor that an issuer can rely on
and all issuers in alternative 2 that just has a cap, they wouldn't need
to calculate each year what their average variable costs for authorizing,
clearing and settling a transaction would be, reporting that cost to the network,
and therefore the network would know what the maximum permissible interchange fee would be
for that issuer.
They'd be able to just rely on those numbers.
So between the economic incentive and the reduced administrative burden,
we thought it would be desirable to have those value limits in the standards,
but it is something that we've requested comment on.
GOVERNOR WARSH: In response to the Chairman's question about the market failures,
about the competitive dynamics and debit interchange,
you talked a bit about the incentives within the debit market.
Can you talk a little bit more broadly about substitutes?
So payments is a highly innovative area.
I presume in the next several years we'll see new means of payment
for on-line transactions and others.
What does our establishment of prices set by the Board in this area do to the broader set
of payment services, so in that context would the utility-setting mechanism here be
pro-competitive if we think about substitutes that might come along the way?
Well, it's interesting, because if you look today, there's certain forms of payment,
the card-based payment, credit and debit cards,
which have this interchange fee associated with them.
There's other forms of payment today, whether it's check or ACH, wire transfers,
that have no interchange fees at all.
So we already are in a mixed environment where certain forms of transaction has this flow
of payment from the payee to the paying bank and other forms of payment don't.
So in the future if innovations are within the debit card space,
and let's say there are more efficient ways to do debit card payments on-line,
they would be subject to these restrictions.
But if we're looking at a totally different form of payment that would be outside of the scope
of the definition of payment card in our rule, they would not be subject to this,
as are a number of other forms of payment that go
against (inaudible) transaction accounts today.
So it's really somewhat difficult to tell how this will change ultimately the competitive
landscape going forward.
GOVERNOR WARSH: Thank you, Mr. Chairman.
Can you talk a little bit about the impact of the exemptions,
of the small institution exemption, the exemption for prepaid cards and then
for government cards, and so how will the existence
of these exemptions impact competition, impact pricing, and impact the usefulness of the cards?
So with regard to the small issuers, we really don't know what the net effect
of the rules will be because it depends on actions to be taken by the networks
and the merchants, and we can't predict those actions.
Both the statute and our proposed rule permit, but do not require,
the networks to establish higher interchange fees
for the exempt issuers than for the covered issuers.
The networks may decide that it's simply too costly or too complicated
to maintain two separate interchange fee schedules, and they may therefore say
that everybody is going to operate on the same interchange fee schedule
which complies with our standards.
In that case obviously the exempt issuers would face a similar reduction
in their interchange fees, as would the covered issuers.
If the networks do decide to establish two separate interchange fee schedules
and allow higher interchange fees for the small issuers,
it's possible that merchants would discriminate against those issuers by declining
to accept their cards because there are higher fees associated with accepting those cards.
Now, currently most, if not all, of the networks have rules in place that would prohibit
that kind of discrimination, but it's not clear how strictly those rules would be enforced,
and it's also possible that the rules would change in the future.
In addition, the exemptions for both the small issuers
and the government programs do not cover the exclusivity and routing provisions of the rules,
and so, for example, small issuers would be required to ensure that their cards can operate
on multiple networks, and there might well be some costs associated with doing that.
If the cards currently don't have the ability to be routed over multiple networks,
then there would be costs associated with meeting the exclusivity requirements,
and likewise for the government cards.
The merchant routing provisions would tend to put downward pressure on interchange fees,
in general, because now the merchants can steer transactions toward lower-cost networks,
and so what we may find is that even
if the networks establish a higher interchange fee schedule for the exempt issuers,
those issuers have somewhat of an increase in cost and somewhat of a decline in their prices,
so they may experience some reduction in their profits from these operations.
With regard to the government programs, the way a lot of the --
a lot of government agencies currently use prepaid cards as a way to --
as a low-cost way to distribute the benefits that they provide,
and the issuers of those cards typically impose little or no cost on the agencies
for issuing the cards because in the current environment they can earn sufficient revenues
through interchange fees to cover their operating costs.
The intent of the exemption of the government cards from the interchange fee restrictions was
to allow that -- excuse me -- that model to persist and to allow these cards to continue to be issued
at relatively low cost to the government agencies.
However, like the small issuers, the government cards are not exempt from the exclusivity
and routing provisions, so again there may be some increasing costs associated
with enabling the cards to operate on multiple networks, and there may be some reduction
in interchange fees simply as market forces come into play
when merchants have choice with regard to routing.
So we don't know what the magnitudes of those adjustments might be,
and it's possible that they would be large enough that the issuers
of the government cards would no longer be able to cover their costs strictly
through interchange fees and they might therefore need to recover some costs
from the agencies themselves, increasing the government costs of administering the programs.
GOVERNOR DUKE: Just one more question on the exclusivity and routing provisions.
On the signature transactions, seems to me those are the ones where there's a large number
of transactions that signature is the only method offered.
What is the competitive structure of the networks
in the signature space versus the PIN space?
All right.
So you touched on an important point with regard to the provisions for network exclusivity.
Currently the signature debit networks are proprietary to the card, so they're --
as I understand it, there are no cards in operation today
with two signature networks appearing on the card.
So what that means is if a merchant is faced with a transaction
where the authorization method is signature, the merchant has the only option --
the only option the merchant faces is to route that transaction
over the designated signature network displayed on the card.
Under the exclusivity provisions that we're offering as possible alternatives,
the alternative that would require two signatures networks and two PIN networks,
that is, one network for each method of authorization,
is the only way by which there would be an additional network pressed into service
as a competitive alternative in those situations.
However, stepping back, we would say that because merchants will have additional ability
to steer and to discount in a provision that's entirely separate
from the rule-making we're discussing today, we would say that there will be some pressure
on the signature debit networks just due to the fact that merchants will be able
to have a little more flexibility to send customers in the direction of the PIN.
GOVERNOR DUKE: Thank you, Mr. Chairman.
CHAIRMAN BERNANKE: Governor, Tarullo?
GOVERNOR TARULLO: Thank you, Mr. Chairman.
In his initial presentation of the proposed rule,
Mark noted that there's no well-established economic definition
of incremental costs, at least in a term-of-art sense.
So you have proposed using average variable costs.
In all the comments that you got, and I gather you got a lot of them,
were there other plausible measures or forms of costs suggested
for implementing the concept of incremental?
(laughter) Plausible.
You can limit yourself to the plausible.
So I think that the three major alternatives that were presented were the ones
that I discussed in my presentation.
The first would be marginal cost.
The second would be something along the lines of average variable cost,
and the third would be something like average total cost.
GOVERNOR TARULLO: That's kind of not plausible, given the language of the statute.
And that's what we used -- that's what we exclude fixed cost.
So those were the three major alternatives that people would propose, and we ended up with one
that was essentially in the middle.
And so, Mark, on the -- the comment you proposed using marginal cost, what was the --
their argument, other than the fact it was probably lower?
I get that, but -- It's interpretation.
GOVERNOR TARULLO: What was the legal argument?
I don't believe we ever got any comments that were that detailed.
It was simply their interpretation of the incremental cost would be as marginal cost
and that would be where they would come from.
Thanks. Secondly, you've proposed using a safe harbor,
and putting aside for a moment the important question that Governor Warsh raises
about whether we should or should not have safe harbor, assuming that we do,
why use the median price as opposed to maybe a --
or median cost, excuse me, as opposed to a lower cost?
Well, we looked at a number of different options.
We thought about median cost, we thought about average -- two forms of average cost.
One would be a simple average, taking the average costs of each
of the issuers and averaging that.
Another one being a weighted average based on the transactions.
The simple average ended up skewing very high because there were some issuers
with very high costs that, frankly, in several cases were higher
than the interchange fees that they receive today.
And there were some, when we looked at the weighted average, weighted by transactions,
that ended up skewing very low just because there were certain very large issuers
with very low average costs, and we thought that if we put the safe harbor down too low,
that it would be more unlikely that issuers would want to avail themselves of it.
And since one of the purposes of the safe harbor is to enable issuers to avoid the need
for calculating their costs, they would be weighing the administrative costs of doing
so versus the foregone interchange revenue that they would have by relying
on a low safe harbor versus, perhaps, a higher amount that they would be able to receive
if they were to calculate the cost.
So it was more a judgment call.
GOVERNOR TARULLO: But I guess the question is, given that the language of the statute is
that the amount of interchange fee that an issuer shall receive shall be reasonable
and proportional to the cost incurred by the issuer with respect to the transaction,
if you set a safe harbor at 7 cents and the issuer's actual cost is 4 cents,
is that outcome consistent with the statutory requirement?
So we would be deeming any fee at the safe harbor
to be both reasonable and proportional to cost.
So reasonable in that 7 cents is the median of all, and the Board would be deeming
that proportion to be acceptable under the statute.
And we were looking in part at proportional
across the experience of issuers more generally.
Reasonable and proportional doesn't -- is different than equal to or less than cost,
and reasonable and proportional has been in other contexts read to include some profit.
So it's not -- not disallowing some --
we're not required by that language to disallow all profit that might come along.
So the issue is whether 7 cents as a safe harbor is a reasonable amount and is it proportional
to the cost, and I think that the expectation was it is reasonable
and there is a proportion there.
The proportion is within the discretion of the Board to determine.
So -- GOVERNOR TARULLO: So we read "reasonable to the cost" as only applicable
to the proportional part of the test?
So whether something is reasonable --
and then proportional to the cost?
Yes. GOVERNOR TARULLO: And the statute doesn't require the proportion
to be the same for every issuer?
Of course this is a matter we're getting comment on, so, you know,
there's a variety of approaches one could take, and this is -- this is one.
GOVERNOR TARULLO: Third -- my third question is on the --
on this issue of the fraud prevention adjustment,
so first I wanted to clarify my understanding, make sure I understand correctly.
Is it currently -- do we currently anticipate that there will be a rule in place by the time
of the statutory deadline on fraud adjustment -- or fraud prevention adjustment?
It is unlikely we'd be able to have one by April.
What we would probably end up doing is, based on the comments we receive on this proposal,
we would then go back and propose a specific fraud adjustment for comment
that would be much better informed than we are today, based on the input from the commenters.
GOVERNOR TARULLO: And you don't think that that's going to be done
in a sufficiently expeditious manner that we could get out the final rule
by the time of the statutory deadline?
I think that would be unlikely.
Final question is just on -- if you could give me a bit of a litigation update.
I know this doesn't involve us, but there's been a bunch of litigation over the years,
most of it, I think, antitrust based on interchange fees.
Is there anything still pending or have there been any recent decisions
that will affect the economics of the industry against which our rule is going to be judged?
There are still some cases pending, and I don't really know the current status of those cases,
but the cases out there are generally surrounding credit cards more than debit cards.
Credit card interchange fees are generally higher.
And so I don't really think that anything that we're doing here
in our proposal will have any ramifications for the existing lawsuits, or vice versa.
There was a recent Department of Justice settlement involving Visa and MasterCard
which did the types of things that Robin referred to earlier about providing more flexibility,
requiring payors to pay with certain discounts and steering methods, so that may have an effect
on the ability of merchants beyond anything having to do with this.
GOVERNOR TARULLO: Thank you, Mr. Chairman.
GOVERNOR RASKIN: Thank you, Mr. Chairman.
I want to talk a little bit about the functional similarities between debit cards and checks,
because to a great extent a debit card really is just a plastic check, and like a check,
when somebody uses a debit card, it automatically debits
from the consumer's demand deposit account at their bank.
Now, my reading of the statute, and I want to know whether this is correct,
shows sort of a purposeful analogy between the appropriate fee for a purchase
with a debit card to that with a check.
And we know that checks clear at par value.
So my question is, did you take into account this functional similarity of debit cards
to checks or, alternatively, did you compare debit cards
with features of alternative payment methods?
We did take into consideration the similarity between debit card transactions
and check transactions, and this entered into our thought process in thinking
about the allowable costs that an issuer should take into consideration
in determining the maximum permissible interchange fee that they'd be able to receive.
So there's two considerations that the statute put forth: One that you just mentioned
on the similarity between check and debit cards; the other one that directed the Board
to distinguish between the incremental cost of the authorization, clearing and settlement
of a transaction, which we should consider, and other costs that don't relate to debit card --
specific debit card transactions, that we should not consider.
And so taking those both -- those considerations both into account, that's how we determined
that we should probably limit the allowable costs just to those functions
that were specifically mentioned in the statute: Authorization, clearing and settlement.
And as Mark mentioned earlier, we thought about either limiting that further
to just authorization cost, because if you do compare with checks,
in a check transaction the paying bank, which would be the equivalent of the issuing bank,
they incur costs to clear and settle check transactions, but they don't get reimbursed
for those costs from the merchant's bank.
But we thought since Congress explicitly asked us to consider those costs as well,
we would include them in the allowable costs in the proposed rule.
We also looked at whether we should have a more expansive definition of allowable costs
that would go beyond authorization, clearing and settlement and look at other costs
that are specific to a transaction.
Those are costs that the Act is silent on on whether we can take into consideration or not.
So things like the costs associated with rewards programs or if issuing banks --
you know, the costs that they incur
to handle cardholder inquiries about particular transactions.
But again, those are costs that if they were to have been incurred in the check context,
the bank would not be able to get reimbursement of those costs from the payee's bank.
So because of that we did not put them into the bucket of costs that would be considered
in determining what the maximum interchange fee initially would be allowed to have.
So that's really how we took that comparison with check into consideration.
Thank you.
Thank you.
Are there any other questions?
Well, again, thank you.
That was a very -- very helpful discussion.
What we have before us today is not the approval of a final rule but rather agreeing
that we will take the proposal presented by the staff and issue it for further comment,
after which there will be additional work, ultimately resulting in a final rule.
Let me go around and take positions on, again, the proposal to issue
for comment the rule presented by the staff.
Vice Chair?
VICE CHAIR YELLEN: I support issuing the proposed rule for comment,
and I would like to add my thanks to the staff for all of the thought and hard work
that you've put into preparing this very thoughtful proposal.
Governor Warsh?
GOVERNOR WARSH: Thank you, Mr. Chairman.
I too can support putting the rule forward for further comment.
I think we should be bound, as many of the questions suggested, by a couple principles.
One is we're looking for a dynamic, competitive marketplace for payments broadly.
I think recent evidence suggests that we continue to see more convenience, more options,
more choice for consumers, and this is a development that our rules should try
to encourage rather than discourage.
Secondly, it's a new set of responsibilities for the Federal Reserve,
and like Vice Chair Yellen said, I really compliment the staff on bringing together a lot
of economic analysis, consumer-oriented knowledge in terms of how they're going
to understand differences in these provisions, and legal knowledge.
So it's a new set of responsibilities for us, and in part because of
that I think we should be particularly keen to listen
to comments and hear people's perspectives.
And then finally the other principle is it's not our job to substitute our judgment
for the judgment of Congress, and Congress has given us some clarity on rules
and what our regulations should suggest, and we should try to adhere as best we can to it.
So with that I do support the proposal.
I think I'd be particularly interested in comments on whether there is a viable,
more pro-competitive alternative to setting prices consistent again with the legislation,
and secondly, understanding better the impact of the proposed rule,
the broad set of payment options available to consumers
so we continue the trend towards a more dynamic and competitive environment.
Governor Duke?
I support putting forth the proposal and would like to add my compliments to staff.
I think you've done an excellent job
of identifying issues, so we'll get robust comments.
Thank you for the work you've already put into it and you have my sympathy
for the work you have ahead of you.
(laughter) Thank you.
GOVERNOR TARULLO: Thank you, Mr. Chairman.
I also can support issuing the proposed rules but, echoing a bit of what Governor Warsh said,
I think we need to be particularly open-minded here to comments.
I mean, sometimes when we put out a proposed rule we are pretty convinced
that we've got it basically right absent something coming in, and I think that difficulties
in implementing this legislation, the subtleties that the staff has already had to deploy
in coming up with a proposal both suggest to me that we should be more than, perhaps,
usually open to a variety of comments on how to implement the final rule.
But with that I'm happy to vote for this proposal.
Governor Raskin?
GOVERNOR RASKIN: Thank you, Mr. Chairman and thank you also to the staff.
I too believe it's critical that the Board move forward with beginning the process
of requesting comments on this proposed rule.
I want to say a couple of things that I think is -- that's been brought out through this process.
First of all, the interchange fee system is one that is pretty much hidden from consumers
and the public, and most people have no idea that interchange fees exist
and that they're paying for services that they may not even use.
As you've brought out, the interchange fee is set by the issuing bank, paid by the merchant,
and the merchant, as you told us, likely passes the fee on to the consumer in the form
of higher prices for the underlying product or service.
And as a result it's highly likely that all consumers,
whether or not they are using a debit card for their purchase, are paying more at the store,
paying more at the pump, because these interchange fees are being passed on to them,
again, regardless of whether or not they're using the debit card for their purchase or not.
In addition to potentially higher prices, the nontransparent nature
of the interchange fee suggests that these interchange fees may or may not be in line
with the cost to banks that are offering these debit cards,
and I think what this rule-making is doing, what this process is doing is it's an attempt
to ascertain these costs and determine whether, in fact, they're reasonable,
or more precisely from the terms of the statute, whether they are reasonable and proportional,
and that's what's stated in the law.
So this process is intended to understand the nature of those costs and determine whether,
in fact, they're reasonable and then require
that the interchange fee be in line with those costs.
And I think what we've heard in other comments around the table is this kind
of regulatory intervention in which a regulator has to intervene in a market
to better align pricing with costs is unusual.
In my mind, the directive for this kind of intervention results from a market
that is working less than competitively, and from that perspective I would note
that the credit card-issuing market has become significantly more concentrated
over the past few years as numerous card issuers have merged.
And the card network, as we know, also is dominated by only a few, in fact, two players,
and there appear to be substantial barriers to entry.
So these market features have had significant consequences for consumers.
Now, we know it's not this rule's intent to do more than what Congress has directed,
so it's worth noting that this kind of regulatory intervention will not be a palliative
to all the wrongs that may arise from the structure of this industry.
Finally, I just want to underscore, as is the case with all regulations,
that the effectiveness of a particular regulation depends in part on its ability
to be complied with, its ability to be enforced, and the diligence
and care that's used in that enforcement effort.
So like all other regulations, once a debit card interchange fee regulation is adopted,
the expectation is that it's going to require enforcement by all
of the applicable bank regulators.
In other words, the bank examiners will need to examine issuing banks for compliance
with the final form of this regulation, and supervisory and enforcement action
for noncompliance would be expected to follow.
Thank you.
CHAIRMAN BERNANKE: Thank you very much.
I too can support issuance of this proposal for comments.
Again, this is a very complex area.
Within the parameters set by Congress it's very important that we, as Governor Warsh said,
do all we can to preserve the dynamism, competition and innovation in payments,
which has obviously been an important feature of that area for quite a long time,
and at the same time, as Governor Raskin was indicating, we should do all we can
to minimize the administrative and regulatory burden implied by these rules.
But with those injunctions, I think we can now take a vote
to formally approve the issuance of this rule for public comment.
May I have a motion?
All in favor of approving this proposal for comment?
Aye. CHAIRMAN BERNANKE: Any opposed?
All right.
Motion passes.
Again, thank you very much to the staff.
Thank you to the audience for your attention, and the meeting is adjourned.