Fed Up: Judge Strikes Down Federal Reserve on Swipe Fees

The Fed holds all the cards when it sets a policy.  Nobody bothered telling that to a federal judge, who last week struck down a Fed regulation on debit card swipe fees.

The Fed holds all the cards when it sets policy. Nobody bothered telling that to a federal judge, who last week struck down a Fed regulation on debit card swipe fees.

When it comes to bailouts, monetary policy, and banking regulation, the Federal Reserve has the last word. No one – not the President, not Congress, not anyone – stops the Fed from doing what it has determined to do. Until last week.

In the most significant ruling you probably never heard of (NACS v. Federal Reserve), Federal District Court Judge Richard J. Leon last Wednesday invalidated a regulation written by the Federal Reserve on debit card “swipe fees.”

“The Court concludes,” Leon wrote, “that the [Federal Reserve] Board has clearly disregarded Congress’s statutory intent by inappropriately inflating all debit card transaction fees by billions of dollars.” [pages 1-2]

“Clearly disregard[ing]” Congress and anyone else who might object to its policies is standard operating procedure at the Fed. What makes this case so special – potentially even historic – is that the Fed has been held accountable, considered subject to the law and not beyond its reach. A federal judge has pronounced its regulation illegal and said that it can no longer permit banks to “inflat[e] all debit card transaction fees by billions of dollars.”

Accustomed as it is to moving trillions of dollars around with impunity, officials at the Fed must have been stunned to be told that the law forbids them to authorize big banks, in direct contravention of federal law, to shake down consumers and merchants for a few trifling billion.

Before going further: an explanation and a disclosure. First, the explanation. Swipe fees are hidden fees charged by your bank every time you swipe your debit card. These fees are charged to the merchant. If you pay a merchant $100 in cash or write her a $100 check, her company’s bank account is credited with $100. If you swipe your debit card, she will be credited with something like $99. That may not sound like much, but it adds up. Citing a brief by the National Association of Convenience Stores, Judge Leon noted that, “For most retailers, debit card fees represent the single largest operating expense behind payroll.” [p. 7]

Merchants recognize the value of accepting these cards as payment and are willing to pay a fee. What caused them to seek legislative relief was that the fees are not negotiated, but dictated by the two largest card networks, Visa and MasterCard. They are in a position to dictate those fees because they dominate the market. Judge Leon’s opinion observed that “networks under Visa’s and MasterCard’s ownership account for roughly 83 percent of all debit transactions and nearly 100 percent of signature transactions [transactions in which you swipe your debit card but don’t enter your PIN].” [p. 7]

Banks that issue cards with one of these brands are guaranteed to collect swipe fees every time that card is used. They’re also guaranteed that they don’t have to compete with other banks over the size of those fees. Visa and MasterCard set the rates and they are the same for every bank in the network. “Within each network, issuers all receive the same interchange fee,” Judge Leon wrote, “regardless of their efficiency in processing transactions or their efforts to prevent fraud.” [p. 8]

Banks that compete over mortgage rates, auto loan rates, CD rates and the like never compete over swipe fees. They are centrally set by the big card networks. There is no competition between banks.

There is, however, a competition between Visa and MasterCard for banks. To convince banks to issue their brand of card, each network has an incentive to raise its swipe fees. The higher the fee, the more the bank will collect with each swipe. So Visa and MasterCard continually raise their rates to keep the banks they have within their network and lure new ones in. Judge Leon described how these perverse incentives work.

“Visa, MasterCard, and other debit networks vie for issuers [i.e., banks] to issue cards that run on their respective networks. They can entice issuers by emphasizing their relative market power and ability to set interchange and other fees. Networks thus have an incentive to continuously raise merchants’ interchange fees — which, again, flow from merchants to issuers — as a way to attract issuers to the network.” [pp. 7-8]

Over the years, that “flow from merchants to issuers” has become a torrent. Judge Leon noted that, “In recent years, interchange fees have climbed sharply.” [p. 6]  Overall, Judge Leon’s opinion notes, “from 1998 to 2006 merchants faced a 234 percent increase in interchange fees for PIN transactions (transactions when you enter your PIN) and by 2009, interchange fee revenue for debit cards totaled $16.2 billion.” [pp. 6-7]

To address this issue, a coalition of merchants asked Congress to enact legislation to curb debit swipe fees charged by the largest banks. Which brings me to the disclosure: before retiring, I represented this coalition in its successful advocacy of this legislation.

Known as the “Durbin amendment,” after its lead Senate sponsor, Dick Durbin (D-IL), the legislation placed limits on debit card swipe fees collected by banks with more than $10 billion in assets. About 1.4 percent of financial institutions meet this threshold, meaning that 98.6 percent of banks and credit unions are exempt from Durbin amendment’s limits on their debit fees.  Those that are not exempt can escape those limits if they set their own swipe fee rates. If, for example, giants like Chase or Bank of America developed its own swipe fee schedule, rather than relying on Visa’s price-fixing, the Durbin amendment would not apply to them.

The act directed the Federal Reserve to write regulations requiring that debit swipe fees collected by covered banks “shall be reasonable and proportional to the cost incurred by the issuer with respect to the transaction.” [Section 1075 of the Dodd-Frank Wall Street Reform and Consumer Protection Act] The provision drew a bright line between costs that were “incurred … with respect to the transaction” and those that were not. It required the Federal Reserve to take into account costs of authorizing, clearing and settling a particular transaction; it prohibited them from taking “other costs” that are “not specific to a particular transaction into account.”

In its final rule, the Fed ignored this distinction, allowing banks to pad their fees by including all manner of costs not arising from specific swipe fee transactions. The practical result of the Fed’s willful misinterpretation of the law was that it invited Visa and MasterCard to use their price-fixing power to levy a 21 cent fee on even the smallest transactions, like a pack of gum or a cup of coffee. They jumped at the chance. Their new, higher fees on small ticket items produced not only higher swipe fees on purchases under $12, they also raised consumer prices for everything from movie rentals (“Red Box”) to parking meters (“Park Mobile”).

The banks and their supporters were quick to blame the Durbin Amendment for these results. Now a federal judge has determined that the problem wasn’t with the law, but with the Federal Reserve’s decision to ignore it.

“The Board’s interpretation,” in raising allowable fees by including costs that the law forbade them to include, “is utterly indefensible,” Judge Leon wrote. “The statute is not silent or ambiguous. Rather, the plain text … and the statutory structure and legislative history of the Durbin Amendment clearly demonstrate that Congress intended for the Board to exclude all ‘other costs’ not specified in the statute.” (p. 40)

Judge Leon’s criticisms were harsh. The Fed’s argument on including costs that the law forbids it to include “makes no sense” (p. 33) and “defies common sense” (p. 35); the law told the Fed to look at only incremental costs and “that’s it!” (p. 37); the Fed’s position is “irreconcilable with the statute” (p. 37) and “contrary to the expressed will of Congress” (p. 38); it “runs completely afoul of the [law’s] text, design and purpose” (p. 39) and “contradicts Congress’s clear mandate” (p. 40); the Fed cannot “flout the statute” (p. 42); its interpretation is “impermissible” (p. 42); it is “fundamentally deficient” (p. 55); the Fed “interpreted the law in ways that were clearly foreclosed by Congress” (p. 55); its rule is a “blatant act of policymaking that runs counter to Congress’s will” (p. 44).

In short, the judge concluded that the Fed’s regulation is contrary to law and irredeemably so.

“Ultimately, the Board asserts that it was given broad discretion to … establish[] the interchange transaction fee standard. But even if this were true, which it is not, such discretion does not give the Board the authority to ignore the expressed will of Congress. By including in the interchange fee standard costs that are expressly prohibited by the statute, the final regulation represents a significant price increase over pre-Durbin Amendment rates for small-ticket debit transactions under the $12 threshold. Congress did not empower the Board to make policy judgments that would result in significantly higher interchange rates. Accordingly, the Board’s interpretation of the interchange fee standard is foreclosed by the law and must be invalidated.” [pp. 45-46]

Judge Leon said that the Fed must shred the regulation and start over. He will hear further argument from both sides as to timing, but he made clear that he expects the Fed to write a new rule – this time one that follows the law — “within months, not years” (p. 57). In the meantime, the current regulation will temporarily stand.

Judge Leon will not necessarily have the last word. The Fed can appeal his ruling. If it does, the process could drag on for quite some time. But the lesson from this case is nonetheless clear: the Fed’s extraordinary powers do not free it from the law’s constraints. Courts have an obligation to apply that law, even to an agency unaccustomed to being contradicted.

Like Judge Leon, President Obama has an opportunity to remind the Federal Reserve that it is not free to do as it pleases. He recently signaled in a “60 Minutes” interview that he would not reappoint Ben Bernanke as Fed Chairman when his term expires next January. That announcement has set off weeks of speculation over who will be the next Fed Chairman.  Published reports suggest that the President will choose between his erstwhile economic adviser Larry Summers and the Fed’s current Vice Chair Janet Yellen.  Many Democrats have weighed in on behalf of Yellen, who has served at the Fed throughout the period during which Bernanke engineered bailouts, established a zero interest rate policy, and took trillions of dollars in government and mortgage-backed debt onto its balance sheet.

The President should take this opportunity to grill prospective nominees. What was the Federal Reserve’s role in creating the housing bubble? Why didn’t it see the resulting financial and economic calamity coming? Should the Fed, as it did in the 2008 AIG bailout, print money to pay foreign banks 100 percent of what they were owed by a failing US company? Will the prospective nominee support a full and independent audit of the Fed and greater transparency into its processes? What damage has five years of the Fed’s zero-interest rate policy done to savers and people living on fixed incomes? Should the Fed continue to pursue policies that contribute to inequality by driving up stock prices as wages deteriorate and workforce participation rates decline?  When will the Fed begin to sell off the bonds it has bought? Can it do so without crashing the stock market and roiling bond markets?

The President should not nominate anyone unwilling to answer these questions clearly and forthrightly. Once confirmed by the Senate, the new Fed Chairman will hold enormous power for years after the President leaves office. Now is the President’s last, best chance to hold him or her accountable.

Judge Leon has shown that it can be done.