Interchange and free checking

By Felix Salmon
June 17, 2010

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.

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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.

Because some of Adams’s predictions are a bit vague, let’s drill down to the one where it’s easy to get hard data from his own credit union. Let’s look at the number of checks that Adams processes per checking account on the day that interchange regulations are signed into law (assuming that happens), and one year later. If it’s risen, I’ll be proved wrong, and will happily donate $100 of my own money to his credit union. If it has fallen, I’d like him to write a $100 check to my own credit union, Lower East Side People’s. Deal?

The fact is that if the biggest and most efficient banks in the world can’t make money from providing checking accounts to low- and moderate-income individuals, then it’s not going to be easy for credit unions to do so either, especially because low-income individuals tend to be high-touch customers who do a lot of their transactions at the teller window. Credit unions like St Louis Community and LES People’s pay for the cost of providing those checking accounts in many different ways, including, when we’re fortunate, getting large donations from the federal government.

In recent years, I can well believe that St Louis Community has been very happy to see its interchange income rise, especially from its signature debit cards. Signature debit is a low-security, high-fraud product, but it’s also very lucrative for banks: it’s so lucrative, in fact, that many of them strongly encourage their customers to use them by offering back cash or other rewards. They wouldn’t do that if their interchange fee revenue was eaten up in fraud costs. At places like St Louis Community, the customers don’t have the option of choosing a reward card, so all that money flows straight to the credit union instead.

St Louis Community is keen on extracting other fees from its customers, too: it’s urging all of them to opt in to its “Overdraft Privilege Service”, in which customers have the privilege of paying $15 when their debit card transaction brings their checking-account balance below zero. Yes, that’s lower than most bank overdraft fees — but the fact is that for most people, in most circumstances, they’d be better off simply seeing their debit or ATM transaction denied if they don’t have the money in their account. This service might be “a life-line when emergencies happen”, to quote the website, but the overwhelming majority of overdraft fees are not racked up in emergency situations, and indeed the customer never has the option whether or not to pay the fee: the money is debited and the fee is charged automatically.

The economics of low- and moderate-income credit unions are not easy, and certainly the loss of interchange fee revenue is going to make it harder to find those $300 of profits per checking account needed to cover costs. But it’s wrong to simply try to extract ever-rising fees from merchants as card usage rises and people write fewer and fewer checks which need, by law, to be redeemed at par. The fact is that if one of Adams’s customers wants to pay for an item, then PIN debit is by far the cheapest way of doing it, from the credit union’s perspective — there’s no cash handling at the teller or the ATM, there’s no check processing, the money just automagically leaves one account and enters another. Debit cards are a great way of bringing credit unions’ costs down. That should be enough: they shouldn’t be a major profit center in their own right.

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