How Dodd-Frank is Killing Free Checking

Friday, October 21st, 2011 at 2:33 pm, by Margarita Kelrikh

On September 29, 2011, Bank of America announced that it would institute $5 monthly debit card fees, effective early 2012. The announcement, which was met with much furor, is a result of new banking regulations that have rolled out with the passage of the Dodd-Frank Act. Specifically, it was the bank’s reaction to the Durbin Amendment, a last minute addition to the Dodd-Frank Act that severely limited the amount that banks could collect in debit card interchange fees.

The Durbin Amendment was the culmination of Senator Dick Durbin’s years-long effort to repair a perceived market failure. Merchants were paying upwards of 44 cents per debit card transaction, far more than it actually cost the banks to process the transaction. These high fees were the combined result of a lack of competition in the market (which can be described at best as an oligopoly, and at worst as a duopoly consisting of Visa and Mastercard) and the lack of bargaining power of small merchants. To remedy this, the Durbin Amendment required banks to charge interchange fees that were “reasonable and proportional to the actual cost” of the transaction. To this end, the Federal Reserve was given the authority to regulate interchange fees.

In June, the Federal Reserve announced that interchange fees could not exceed 21 cents per transaction, plus .05% of the purchase amount. This is expected to cost banks approximately $5 billion annually. Banks have reacted by passing this cost to consumers in the form of increased debit and checking fees. Though Bank of America is by far the largest bank to have implemented such a program thus far, many smaller banks have been experimenting with $3-4 dollar fees for debit card usage. Similarly, Citibank has announced its intentions to begin charging for checking accounts.

In theory, the reduced merchant costs would be passed along to consumers in the form of lower prices. The Durbin Amendment makes this especially easy by allowing merchants to price discriminate depending on form of payment (something that credit card companies effectively made impossible in the past, contractually requiring merchants to treat credit card transactions as favorably as other forms of payment). However, this is unlikely to occur for several reasons. First, merchants are far more likely to simply pocket the gains than pass them on to consumers (in much the same way that airlines failed to pass along the gains when Congress did not pass the bill funding the Federal Aviation Administration, and the FAA lost the ability to levy taxes on airline tickets). Moreover, the fact that consumers most likely do not expect merchants to lower prices will only foster the expected result. The public typically does not scrutinize small businesses in the same way as banks. Because retail consumers have never been directly charged interchange fees, it is unlikely that they would expect retailers to lower prices. In short, there is little incentive for retailers, big or small, to lower prices as increased banking fees will have little effect on the demand for their products.

On its face, it seems like perhaps an alternative should have been to limit the interchange fee maximum to small or medium retailers, and allow banks to charge large fees to big-box retailers, such as Wal-Mart. Beyond the fact that this would have likely been a political impossibility, (given Wal-Mart’s heavy lobbying for the passage of the Durbin Amendment), the economic result would have been essentially the same. Wal-Mart and its peers do not suffer from bargaining power inequalities as small and medium retailers often do. Presumably, Wal-Mart would not stand for higher interchange fees, and banks and credit card companies would not risk losing large chunks of business. Furthermore, big-box retailers have historically been able to negotiate lower interchange fees with credit card companies themselves. As a result, any price decreases that are possible may have already been extended to consumers.

However, a lack of price decreases is unlikely to have the same economic and psychological effect on consumers as an increase in banking costs. In addition to the Durbin Amendment, other Dodd-Frank provisions promise to change the face of consumer banking as we know it. For example, another new rule requires banks to ask customers to opt-in to automatic overdraft programs. Previously, banks provided automatic overdrafts as a so-called courtesy service to customers, and in exchange they would levy high fees each time a customer withdrew more than his balance. A 2008 study by the FDIC found that such fees ranged from $10 to $38, and with the median fee at $27.

Although overdraft fees have long been severely criticized, their existence most likely played a significant role in a bank’s ability to offer free checking services. Historically, overdraft fees have been huge moneymakers for banks. In 2009, banks earned approximately $38.5 billion dollars from overdraft fees.  While some of the loss is mitigated by the over 100 million Americans who have actually elected to opt into to overdraft fees, some sources estimate that the rule change will cost banks more losses in revenue than any other regulation.

Interestingly, the same FDIC study found that over 93 percent of the revenues from overdraft fees come from the 14 percent of banking customers who overdraft on their accounts more than 5 times a year. The fall-out from the new opt-in rule will be felt by a broader number of banking customers, including the approximately 75 percent of the population that has never incurred an overdraft fee.

With significant revenue losses from new rules such as the opt-in rule and the minimization of interchange fees, banks have turned to new sources of revenue. Many free checking accounts at large banks are simply no longer profitable, and banks are now charging for services that they used to provide for free. On the whole, one can argue that this is a positive paradigm shift for checking accounts. Checking accounts are a valuable service that banks provide, and consumers will simply get used to paying for the security and convenience of these accounts, in much the same way that consumers once had to adjust to paying for internet. In exchange, they will be dealing with a more conscientious banking regime, in which their fees will not be hidden, and small businesses will not be steamrolled by powerful banks. On the other hand, this might just be optimistic speculation. Ultimately, whether this will lead to a consumer banking renaissance or a consumer banking armageddon remains to seen.