Interchange Fees Reform and the Risk of Worsening Debanking

The issue of "debanking," where financial institutions deny or withdraw banking services from certain individuals, is gaining prominence in policy discussions in the US and other parts of the world. While often seen through a political lens, the economic implications are pressing, particularly in the context of interchange fees reform.

Interchange Fees Reform: A Double-Edged Sword

Recent data highlights that over 5.6 million households in the US are unbanked, with minority communities being disproportionately affected. In this landscape, a new Federal Reserve proposal to cap debit card interchange fees could inadvertently exacerbate the issue of financial exclusion.

Debit cards are the predominant payment method for individuals living paycheck to paycheck, who generally maintain low account balances. Interchange fees on these debit transactions help banks cover the costs of offering accounts with low balances. A cap on these fees might disincentivize banks from providing such services, potentially leading to more debanking.

The Trade-Off Between Interchange and Overdraft Fees

The Federal Reserve intends to lower debit card swipe fees to reduce costs for merchants and consumers. However, this could lead to banks relying more on overdraft fees to make up for lost revenue, a practice that disproportionately affects financially vulnerable customers.

The logic is simple: if banks can't depend on interchange income from low-margin accounts, they might stop offering them or revert to punitive fee structures. Some banks that previously relied on overdraft charges have made strides by reforming their fee models or introducing no-overdraft "Bank On" accounts. The Fed's proposal, however, risks undoing these advancements.

Structural Inconsistencies and Market Distortions

The proposed regulation contains inconsistencies. Under the Durbin Amendment, small banks and credit unions are exempt from interchange caps, allowing them to charge higher swipe fees. Many of these institutions still heavily rely on overdraft fees, sometimes as their main profit source.

This grants them an advantage of higher swipe fees and the freedom to impose overdraft charges, distorting the competitive landscape and harming consumers. This loophole has led to partnerships between fintech companies and small banks, with fintechs providing the digital interface while partner banks benefit from unrestricted interchange revenue.

While fintechs have promoted fee-free accounts and expanded financial inclusion, concerns about regulatory oversight and consumer protection remain. The collapse of fintech platform Synapse underscored risks in fund custody and the limits of deposit insurance.

A More Targeted Approach

To better support financial inclusion, a more nuanced approach to interchange fees is needed. The Fed could exempt "Bank On" style accounts — those with no overdraft fees — from lower interchange rates, directly incentivizing larger banks to offer safer, affordable products. This would align economic incentives with social outcomes, reducing reliance on punitive fees and encouraging banks to serve low-income consumers.

With economic pressures mounting and millions financially excluded, regulatory missteps could worsen the problem. Reforms aimed at lowering costs should not compromise access. The Fed faces a critical choice and should prioritize policies that promote inclusion rather than accelerate exclusion.

In conclusion, while the intent behind the interchange fees reform is to lower costs, it poses risks to financial accessibility and could deepen the issue of debanking. A balanced approach that incentivizes inclusive banking practices can help mitigate these risks and foster a more equitable financial landscape.