The Impact of Debit Card Regulation on Checking Account Fees

By Richard J. Sullivan

n 2010, when Congress authorized the Federal Reserve to cap the fees paid to banks for debit card transactions, some news reports predicted the banks might react by increasing checking account fees. The cap on debit card fees reduced revenue signicantly for some banks, and the concern was that they might seek to offset their losses by raising more revenue from checking accounts. In fact, in recent years, many of the large banks bound by the new debit card regulations have raised their checking account fees. But thousands of smaller banks that were exempted from the regulations have taken varying approaches to checking account fees. Some have raised the fees. Others have lowered them. The net effect on consumers has remained an open question. After the imposition of debit card regulations, have changes in checking account fees beneted or hurt bank customers? What factors drove some banks to change their fees and others not? Were competitive forces important in the banks decisions? This article examines broad samples of regulated and exempt banks, compares their fee structures before and after the imposition of debit card regulations, and nds thaton netconsumers actually had increased access to free checking after the debit card regulations went into effect in late 2011. Regulated banks were more likely to raise checking account fees, but exempt banks were more likely to reduce or eliminate

Richard J. Sullivan is a senior economist at the Federal Reserve Bank of Kansas City. This article is on the banks website at www.KansasCityFed.org.

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Page numbering will change upon this articles inclusion in the coming issue of the Economic Review.

fees. Thus, consumers net increase in access to free checking stemmed mainly from the greater availability of free checking at exempt banks. At some banks, both regulated and exempt, there were also other changes in the terms of the checking accounts offered to consumers. This article nds evidence that access to free checking has expanded most in cities and regions where banks are engaged in vigorous competition: banks in such markets may offer free checking to attract customers from other banks or to ensure retention of their own established customers. Section I describes the potential for debit card regulations to drive changes in checking account fees and outlines an approach to assessing what changes actually occurredcomparing data from before and after the regulations were imposed. Section II examines the changes in checking account fees that have occurred and explores banks decisions on whether to offer unconditional free accounts or conditional free accounts for which customers must meet certain terms and conditions to avoid fees. Section III examines the market characteristics, nancial factors, and competitive conditions that may have driven changes in checking account fees.

I. DEBIT CARD PAYMENTS, BANK ACCOUNT SERVICES, AND INTERCHANGE FEES

The changes in checking account fees that took place from 2011 to 2012 came after a decade of striking developments in the debit card market. Debit card use from 2000 to 2009 had soared from 12 percent to 39 percent of all noncash retail transactions, even as the number of those transactions swelled from 72 billion to 104 billion per year (Sullivan 2012). Over the same period, debit card networks sharply raised the fees charged to merchants for processing transactions. The largest share of these fees, known as interchange fees, is passed on by the networks to the banks that issue debit cards. Interchange fees increased 33 percent from 2000 to 2011, rising from an average of 36 cents to an average of 48 cents for a $40 transaction.1 Merchants raised concerns about the rise in interchange fees and subsequently, Congress passed the Dodd-Frank Act of 2010, which included a cap on interchange fees.2 The cap took effect in October 2011.3 Congress exempted smaller banksbanks with parent companies having less than $10 billion in total assetsfrom the cap, but

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larger banks were bound by the cap and experienced immediate losses of revenue. For the regulated banks, the average interchange fee (counting fees for transactions of all sizes) quickly dropped from 50 cents to 24 cents per transaction (Hayashi 2012). Annual revenue from interchange fees dropped for all regulated banks by an estimated $8 billion (Wang).4

The reaction of banks to regulated interchange fees

Amid uncertainty about how regulated banks would react to these revenue losses, some banking industry observers predicted a rise in checking account fees and widespread elimination of free checking accounts for consumers. Other observers predicted survival of free checking at small banks.5 Both predictions are defensible because a variety of factors inuence how commercial banks manage the pricing and costs of checking account services.6 Although the loss of revenue from interchange fees is one key factor, other factors also inuence prices, including: the characteristics of the regional market in which a given bank operates; the nancial characteristics of the individual bank itself; and the nature of the industry competition faced by the bank. For example, in regional markets that are growing in size and afuence, banks may place a higher value on gaining market share than on increasing account fees. Individual banks nancial characteristics, such as their access to funding or the level of demand for their loans, may affect those banks decisions on whether to raise account fees.7 And the nature of the competition faced by banks within their regional market may inuence whether they are inclined to raise fees at the risk of losing price-sensitive customers to rivals. Numerous factors inuence banks management of checking account products and their reactions to interchange fee caps have not been uniform. Loss of interchange fee revenue is likely to lead some regulated banks, but not all, to raise account fees. While interchange fee regulation does not apply to exempt banks directly, it may have had an indirect effect on the pricing of some checking account products. After a regulated bank raises its checking account fees, rival banksincluding exempt banksmay follow with their own fee increases because they perceive less risk of losing customers. Conversely, an exempt bank may react by lowering its own account fees in a competitive move to attract customers.

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The before-and-after method used to analyze checking account requirements and fees
In studying how commercial banks reacted to the regulation of debit card interchange fees, this article examines separate samples of regulated and exempt banks. The analysis compares consumer checking account, nancial, market, and competitive characteristics of sample banks before and after interchange fee caps went into effect. The rst set of data on fees and requirements of banks consumer checking accounts was collected in March and April 2011, at least ve months before fees were regulated. A second set of data was collected in April to June 2012, six months or more after fees were regulated. A criticism of this before-and-after method is that other factors may account for the changes it uncovers. A potential complication in the case of deposit services was a change in regulations, effective July 21, 2011, that allowed banks to pay interest on business checking accounts.8 This change may account for a surge of checking account balances, which in 2011 increased 35 percent at commercial banks.9 The banks new ability to pay interest on business checking accounts most likely caused the large increase in overall checking account balances rather than interchange fee regulation. In a recent survey on corporate payments, less than 5 percent of 484 respondents used or accepted debit cards in transactions with suppliers or other businesses (Association for Financial Professionals). Moreover, because business checking accounts are tied to a broad range of servicespayroll, wire payments, and bill payment processingfree checking or minimum balances may have little relevance. The emergence of interest payments for business checking accounts complicates the analysis of trends in checking account services in two ways. First, the surge in business checking account balances makes it difcult to detect whether consumers shifted their checking account balances from banks with free checking to banks without free checking because the information about checking account balances mixes consumer and business checking accounts. Second, most business checking account balances are held in larger, regulated banks.10 As a result, the ratio of business deposits to total checking account deposits likely increased, and the increase was likely greater at regulated banks than

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at exempt banks. The analysis below offers a method for isolating the trends in consumer accounts from the trends in business accounts. For several reasons, despite the challenges posed by the nature of the available data, the before-and-after assessment used in this article can help identify what changes in checking account fees were caused by interchange fee regulation. First, the imposition of interchange fee regulation itself denes the distinction between regulated and exempt banks considered in the analysis. Second, although many factors may have some effect on how banks price their deposit services, the interchange fee cap was a major contributor to the differences observed between regulated and exempt banks in their adjustments to the terms and fees of checking accounts. Finally, the regulation of interchange fees for debit card payments is the only distinct, major event in 2011 that directly and substantially affected banks revenue from consumer checking account services.

II. AVAILABILITY AND COST OF COMMERCIAL BANK CHECKING ACCOUNTS

Analysis of checking account requirements and fees at regulated and exempt commercial banks shows some banks raised fees while others reduced them. Change was relatively uniform among regulated banks, which mostly raised fees on checking accounts. Many exempt banks changed their account offerings, however, and while some increased consumer fees, others reduced them. On balance, more exempt banks reduced fees, more than offseting the impact of regulated banks raising of fees. On net, the changes resulted in increased availability of free checking accounts. This section rst discusses sample data on requirements and fees for checking accounts. It then examines the requirements and fees of two types of free checking accounts, unconditional and conditional.11

Sample data and general characteristics of banks

Sample banks are drawn from all 6,389 commercial banks with nonzero checking account deposits at year-end 2010 (Table 1).12 The total population of banks had checking account deposits of $946 billion. In 2010, 163 of these banks were subject to interchange fee regulation and

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Table 1

CHARACTERISTICS OF REGULATED AND EXEMPT COMMERCIAL BANKS, 2010

Sample Characteristic Number Total size Total deposits Checking accounts $5,510 $548 $92.7 $15.4 Regulated 41 Exempt 240 All Banks Regulated 163 Total (billions) $6,692 $652 Percent Share of total checking account deposits at all banks Average size Assets Total deposits Checking accounts $191,451 $134,402 $13,377 $468 $386 $64 58 1.6 69 Average (millions) $59,806 $41,058 $4,002 Percent Checking accounts/assets Return on assets Metro location 8.35 0.55 97.6 20.6 0.36 55.4 9.23 0.83 93.3 22.2 0.28 50.8 21.8 0.30 51.9 $319 $263 $47 $1,836 $1,303 $148 31 100 $1,635 $294 $8,327 $946 Exempt 6,226 Total 6,389

Notes: Banks are grouped according to whether their debit card interchange fees are regulated or exempt from regulation. The sample banks in the regulated group are a non-random sample and the banks in the exempt group are randomly selected from all exempt banks. All statistics in this table are for year-end 2010. Sources: Call Reports, FDIC Summary of Deposits, author calculations.

6,226 were exempt. The shares of checking account deposits at regulated and exempt banks were 69 percent and 31 percent, respectively. The regulated sample includes 41 banks from a list of 100 top issuers of debit cards in 2010 (Nilson 2010a; Nilson 2010b).13 Banks in the regulated sample include many of the largest banks in the United States. The exempt sample contains 240 banks randomly selected from all exempt commercial banks. For each sample bank, fee information and requirements for various noninterest checking account products was obtained directly from the banks website. The 41 banks in the regulated sample held $548 billion, or 58 percent, of all checking account deposits at year-end 2010 (Table 1). By contrast, the 240 banks in the exempt sample combined held $15.4 billion, or 1.6 percent of all checking account deposits. The sample banks have some differences compared with the groups from which they are drawn (Table 1). Average assets of the sample of

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regulated banks were $191 billion at year-end 2010, much higher than the average of $59.8 billion for all regulated banks. The sample of regulated banks had a low return on assets (0.55 percent) compared with all regulated banks (0.83 percent). Average assets of banks in the exempt sample were $468 million, modestly larger than the average of $319 million for all exempt banks. Despite these differences, the samples are likely indicators of how all regulated and exempt commercial banks reacted to interchange fee caps. While the sample of regulated banks is not randomly selected, its members held a substantial majority of all checking account deposits at commercial banks.14 The banks in the exempt sample are slightly larger, on average, than all exempt banks but nonetheless have similar characteristics, including size and geographic distributions, compared with all exempt banks. Additional discussion about Table 1 and the samples of exempt and regulated banks is in Appendix 1.

The availability of free checking accounts for consumers

The dening attributes of a free checking account are that it involves no monthly fees, no minimum balances, and no per-check charges. The accounts typically have other requirements and fees, such as opening-balance requirements, fees for ATM services, and penalty fees for insufcient funds, but these fees are either minimal or are common to all accounts. The availability of free checking accounts for consumers changed both among regulated banks and among exempt banks after the implementation of interchange fee regulations. The share of banks in the regulated sample offering free checking accounts declined sharply from 51 percent in 2011 to 27 percent in 2012 (Chart 1). By contrast, among banks in the exempt sample, the share offering free checking rose from 37 percent in 2011 to 44 percent in 2012. Although the percent decline in the offering of free checking among regulated banks was much larger than the percent rise among exempt banks, the number of exempt banks in the sampleand in the United States as a wholefar exceeds the number of regulated banks. The relatively small increase in the proportion of exempt banks offering free checking had an outsized effect on the overall availability of free checking to consumers, as described in greater detail below.

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Chart 1

SHARE OF BANKS OFFERING FREE CONSUMER CHECKING

60 50 40 30 20 10 Percent 51% 44% 37%

27%

Sample Regulated Banks 2011 2012

Sample Exempt Banks

Notes: Offers of free checking accounts are as of spring 2011 and spring 2012. The bank accounts in this sample have no monthly fees or monthly balance requirement. They may have a minimum opening balance requirement and be subject to fees such as for ATM withdrawals or for nonsufcient funds. Banks are grouped by whether their debit card interchange fees are regulated or exempt from regulation. The shares shown are the percent of the sample observations whose debit card interchange fees are either regulated (41 banks) or exempt from regulation (240 banks). Source: Authors calculations.

Because it is costly for banks to change their deposit account products, it is not surprising to nd that a signicant share of both regulated and exempt sample banks did not change their practice with respect to offering or not offering free checking accounts. Among banks in the regulated sample, 24 percent offered free accounts in both 2011 and 2012, while 46 percent did not in both years (Table 2). Among banks in the exempt sample, 14 percent offered free accounts in both years, while 33 percent did not in either year. On the other hand, some regulated and exempt sample banks were motivated to change their offers of free checking accounts. Among banks in the regulated sample, 2 percent added free accounts and 27 percent dropped free accounts in 2012. Among banks in the exempt sample, 30 percent added free accounts in 2012, and 23 percent dropped free accounts. For those that changed, more regulated banks dropped free checking than added it, while the opposite was true for exempt banks. Another useful measure of consumer access to free checking is the dollar value of checking accounts in banks that offer free checking. A larger bank balance indicates a larger market footprint because it typically means a bank has more customers, branch ofces, and ATMs, and

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Table 2

CHANGE IN OFFERS OF FREE CHECKING TO CONSUMERS, 2011-12

No Change Free Checking Accounts in 2011 Free Checking Accounts in 2012 Sample Regulated banks Exempt banks Yes Yes Number 10 34 Share 24% 14% No No Number 19 80 Share 46% 33% Added No Yes Number 1 71 Share 2% 30% Dropped Yes No Number 11 55 Share 27% 23%

Notes: Offers of free checking accounts are as of spring 2011 and spring 2012. The bank accounts in this sample have no monthly fees or monthly balance requirement. They may have a minimum opening balance requirement and will also be subject to fees such as for ATM withdrawals or cases of nonsufcient funds. Banks in this table are grouped by whether their debit card interchange fees are regulated or exempt from regulation. The shares shown for each type of bankregulated and exemptare the percentage of banks of the given type that followed the pattern as indicated, from 2011 to 2012, of change or no change in the offering of free checking accounts. There are 41 regulated and 240 exempt banks in the sample. Source: Authors calculations.

that it operates in a larger geographic area. If the total value of checking account balances in all banks offering free checking accounts increases, consumers can more easily access free checking. By dollar value, consumer access to free checking increased from 2011 to 2012. The footprint of all commercial banks that offered consumers free checking accounts increased from an estimated $184 billion in 2011 to $278 billion in 2012 (Table 3).15 The share of checking account balances in banks that offer free checking out of all checking account balances rose from 19.4 percent to 21.6 percent. Some of the increase shown in Table 3 in checking account balances held by banks offering free checking may relate not to consumer checking but to business checking accounts that began to pay interest. These interest payments may have altered the composition of checking account balances, by increasing business account balances relative to consumer account balances and by increasing the balances held by regulated banks relative to those held by exempt banks. A counterfactual calculation can be used to account for this likely change in the composition of checking account balancesand to focus narrowly on the change attributable to consumer accounts, as opposed to business accounts. Assuming that the growth of deposits at regulated banks in 2011 was equal to that of exempt banks, the 2011

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Table 3

CHECKING ACCOUNT BALANCES AT ALL BANKS WITH FREE CHECKING, 2011-12

2011 billions All bank checking account balances Balances in banks that offer free checking Regulated banks Exempt banks Total Share of total in all bank checking account balances $138 $46 $184 $96 $182 $278 $946 $1,285 2012

19.4%

21.6%

Notes: Estimates of checking account balances in all banks that offer free checking shown in this table are extrapolated using statistics from the samples of regulated and exempt banks. See Appendix 2 for details. Offers of free checking accounts are as of spring 2011 and spring 2012. Aggregate values of checking accounts are as of year-end 2010 and year-end 2011. The bank accounts in this sample have no monthly fees or monthly balance requirement. They may have a minimum opening balance requirement and will also be subject to fees such as for ATM withdrawals or cases of nonsufcient funds. Banks in this table are grouped according to whether their debit card interchange fees are regulated or exempt from regulation. Sources: Call Reports, FDIC Summary of Deposits, authors calculations.

surge in deposits at regulated banks is eliminated and the ratio of consumer deposits to total deposits is held closer to historical averages. In this calculation, out of all checking account balances in total, the share held by banks offering free checking rose from 19.4 percent in 2011 to 25.3 percent in 2012, a larger increase than that found in Table 3 (see Appendix 2 for details on this calculation). This suggests that interest payments on business checking accounts affected the size, but not the direction, of the estimated change in the share of checking accounts held by banks offering free checking.

Conditional free checking accounts: availability and cost

Conditional free accounts are another common type of checking account. Customers avoid monthly fees by meeting specic requirements, typically a balance requirement, a usage requirement, or both a balance and usage requirement. Typical balance requirements may involve either a minimum daily balance or a minimum average balance, or both. Usage requirements may involve either minimum numbers of debit card payments or an automated deposit with a minimum dollar

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Table 4

AVAILABILITY OF CONDITIONAL FREE CHECKING TO CONSUMERS, 2011-12

Banks Offering Conditional Free Checking Accounts 2011 Sample Regulated banks Balance requirement Usage requirement Balance and usage requirement Exempt banks Balance requirement Usage requirement Balance and usage requirement Number 26 5 7 20 173 33 113 72 Share 63% 8% 17% 48% 72% 14% 47% 30% 2012 Number 33 3 4 31 148 75 40 64 Share 80% 7% 10% 74% 62% 31% 17% 27% Change 2011 to 2012 Number +7 -2 -3 +11 -25 +42 -73 -8 Share +17% -5% -7% 26% -10% 18% -30% -3%

Notes: Free checking conditions are as of spring 2011 and spring 2012. The bank accounts summarized in this table have conditions that, if met, will result in no monthly fee for a checking account. Conditions can be a minimum daily balance, a minimum average balance, one or more direct deposits to the account, a minimum number of debit or other transactions and other conditions such as an all-electronic account or monthly bill payments. Some accounts require more than one of these requirements. They may also have a minimum opening balance requirement and be subject to fees such as for ATM withdrawals or cases of nonsufcient funds. Banks in this table are grouped by whether their debit card interchange fees are regulated or exempt from regulation. The shares in the tables are the percent of the total observations whose debit card interchange fees are either regulated (41 banks) or exempt from regulation (240 banks). Source: Authors calculations.

value, or both. As with free accounts, conditional free accounts typically involve an opening balance requirement or fees such as for ATM use or for insufcient funds. The availability of conditional free accounts increased among banks in the regulated sample and declined among banks in the exempt sample. Banks in the regulated sample that offered conditional free accounts increased 17 percent, from 26 banks in 2011 to 33 banks in 2012 (Table 4). In the exempt bank sample, banks offering conditional free accounts fell from 173 in 2011 to 148 in 2012, a decline of 10 percent. Given the results from free checking account products, some regulated banks likely shifted from unconditional to conditional free accounts while the reverse was likely at exempt banks. Changes in the requirements on conditional free accounts were mixed across banks. Some banks increased usage or balance requirement while others lowered them (Table 5). Whether the change is important to consumers depends on how they use their account.

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Table 5

REQUIREMENTS AND FEES ON CONDITIONAL FREE CHECKING FOR CONSUMERS, 2011-12

Sample Regulated Effect on cost of account due to 2011 to 2012 change in fee or requirement* Exempt Effect on cost of account due to 2011 to 2012 change in fee or requirement*

Type of account /condition Balance requirement Min. opening balance Min. daily balance Min. average balance Monthly fee**

Average fee or requirement 2011 2012

Average fee or requirement 2011 2012

$70 $2,025 $6,000 $15

$33 $1,550 $15,000 $16

+ +

$99 $588 $1,250 $7

$123 $421 $422 $6

+ -

Usage requirement Min. opening balance Direct deposit Debit card transactions Monthly fee** $65 $25 1 $8 $37 $175 2.3 $6 + + $80 $45 N/A $7 $92 $1 9.4 $6 + N/A -

Both requirements Min. opening balance Min. daily balance Min. average balance Direct deposit Debit card transactions Monthly fee** $71 $870 $1,532 $158 3.2 $7.99 $80 $1,656 $1,891 $152 3.0 $7.61 + + + $137 $452 $1,114 $0 15 $7 $89 $358 $489 $44 3.2 $6 + -

Number of conditions where the 2011-12 change in the average fee or requirement: Increases the consumers cost Decreases the consumers cost 7 7 3 10

*A plus or minus indicates that the change from 2011 to 2012 increased or decreased the consumers cost of the account **If requirements not met Notes: Fees and requirements are as of spring 2011 and spring 2012. Cells of the table report the average values of conditions or fees for accounts offered by sample banks. At least one, and possibly more, conditions are required. Accounts chosen for this table are appropriate and available for average customers. For some banks, more than one account may be coded. Banks with special features that are available only to specic groups of customers (students, military, retired, etc.) are excluded. However, the accounts in this table may adjust fees or conditions for specic groups. Banks are grouped by whether their debit card interchange fees are regulated or exempt from regulation. The 41 total banks in the regulated group is a non-random sample and the 240 total banks in the exempt group is a random sample from all exempt banks. Source: Authors calculations.

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For consumers who cannot meet a minimum balance, for example, the most important fee may be the resulting monthly charge on the account. The average monthly fee for an account with only a balance requirement among banks in the regulated sample increased from an average of $15 in 2011 to $16 in 2012, potentially making them more costly to consumers. But the average monthly fee in the other ve type-of-account and sample combinations of the conditional free accounts shown in Table 5 declined from 2011 to 2012, indicating less cost to consumers. The overall picture on monthly fees suggests lower cost to consumers. Another example of a change in a requirement had a neutral effect on potential consumers cost of conditional free checking accounts. The average opening-balance requirement increased from 2011 to 2012 in three of the type-of-account and sample combinations and decreased in the other three combinations. For consumers, the sample suggests little change in the minimum opening balance requirements of conditional free checking accounts. One simple method of summarizing the overall changes to conditional free accounts for consumers is to tally the number of changes in average fees or requirements that either increased or decreased the cost of the account. For each type of account and each account requirement, Table 5 shows whether changes from 2011 to 2012 would increase, indicated with a plus sign, or decrease, indicated with a minus sign, the cost to the consumer of the account. Across the three subcategories of conditional free accounts in Table 5, there are 14 types of fees or requirements. The last two rows of Table 5 show a tally of the effects across all accounts and requirements. By this method, the cost of conditional free accounts did not signicantly change at regulated sample banks, but they fell at banks in the exempt sample. Banks in the regulated sample increased the cost of checking accounts in seven and decreased the cost in seven account requirements or fees. Banks in the exempt sample increased the cost of checking accounts in three and decreased the cost in 10 account requirements or fees. Another indicator of the cost of conditional free checking is the number of requirements to be met to attain free checking. More requirements are harder to meet and thus may more easily result in

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a monthly fee. As shown in Table 4, 48 percent of regulated banks had conditional free accounts with balance and usage requirements in 2011, with this share rising in 2012 to 74 percent. By contrast, only 14 percent of exempt banks had conditional free accounts with balance and usage requirements in 2011, and although the share rose in 2012, it rose only to 31 percent. From 2011 to 2012 regulated banks moved to accounts with more requirementsand thus accounts that were likely more costly for consumerswhile exempt banks moved to accounts with fewer requirements. In fact, in 2012, the most common type of conditional free accounts among banks in the exempt sample were accounts that had only a monthly balance requirement, making it relatively easy for most consumers to avoid monthly fees. Finally, there is little evidence in the samples that regulated or exempt banks increased fees that are common to all accounts. Fees for nonsufcient funds collected from 26 regulated and 59 exempt banks in the samples show, on average, little change. The average for banks in the regulated sample was $31.15 in 2011 and $32.30 in 2012. For banks in the exempt sample, the average was $28.52 in 2011 and $28.49 in 2012. For all sample banks, total revenue from ATM fees and account service charges did not increase appreciably during 2011 and 2012 (Chart 2).16

Summary of changes in free checking and conditional free checking

Information from samples of exempt and regulated banks suggests that free checking became more available to consumers after interchange fee regulation went into effect. Free checking was less available at regulated banks but more available at exempt banks. The share of checking account balances in banks that offer free checking rose to an estimated 21.6 percent in 2012, up from 19.4 percent in 2011. Conditional free account products became more expensive and complex at regulated banks and less expensive and complex at exempt banks.

III. FACTORS AFFECTING THE PRICING OF CHECKING ACCOUNTS Regulation of interchange fees on debit card transactions was unlikely to be the only factor in the decision of banks to change requirements and fees for checking accounts. Economic forces also may have

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Chart 2

OTHER REVENUE FROM DEPOSIT ACCOUNT SERVICES FOR SAMPLE COMMERCIAL BANKS
A: ATM Fees
$500 $400 $300 $200 $100 Exempt banks (right scale) Thousands Thousands $100 $80 $60 $40 $20

Regulated banks (left scale)

2011:Q1

2011:Q2

2011:Q3

2011:Q4

2012:Q1

2012:Q2

2012:Q3

2012:Q4

B: Service Charges on Deposit Accounts

$8,000 Thousands Regulated banks (left scale) $6,000 $600 Thousands $800

$4,000

$400

$2,000

Exempt banks (right scale)

$200

2011:Q1
Source: Call Reports.

2011:Q2

2011:Q3 2011:Q4 2012:Q1

2012:Q2

2012:Q3

2012:Q4

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inuenced banks pricing decisions. This section examines market, nancial, and competitive characteristics that shaped the incentives of commercial banks in pricing their checking account services. To identify key characteristics, this section compares the group of banks that added free checking accounts to the group that dropped them. Adding or dropping free checking is a major change, and banks that did so most likely faced strong incentives. Studying the conditions under which the two groups made different decisions may identify factors that affected the decisions. The effect of competition is important to bank customers and policymakers because a banks ability to increase checking account fees depends on the competition it faces in the market (Hayashi 2012). Exempt banks, for example, may determine that their best strategy is to lower the costs of their checking accounts to attract new customers, some of whom may be upset with fee increases at their current bank.17 Regulated banks may be reluctant to raise fees if the increase will cause checking account customers to move to a bank with lower fees. This section focuses primarily on exempt banks because the sample of exempt banks is large and representative of all exempt banks. For comparison, the section briey discusses results for banks in the regulated sample.

Banks in the exempt sample

Market characteristics. The characteristics of a local market will determine its attractiveness to a bank and thus affect how aggressively the bank prices account services. In particular, a bank in a large, growing and afuent area may be more successful establishing and retaining a customer base. Market characteristics that differ statistically between exempt banks that added or dropped free checking accounts include location in a metropolitan area and per capita income (Table 6).18 The large population in a metropolitan area may make it easier to attract new customers. A high per capita income signals a greater proportion of the population that would use bank account services. A 67.7 percent share of banks in the exempt sample that added free checking are located in metropolitan areas, compared with 41.8 percent of banks in the exempt sample that dropped free checking. The per capita income in the markets of

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Table 6

MARKET CHARACTERISTICS OF BANKS THAT ADDED OR DROPPED FREE CHECKING Banks in the exempt sample
Added Free Checking Accounts in 2011 Free Checking Accounts in 2012 Number of banks Market characteristics (average) MSA location*** Net migration Population aged 18 to 64 Share of population with at least a high school education Per capita income** Deposits per person 67.6% 0.164% 62.3% 84.5% $22,943 $26,390 41.8% 0.158% 61.7% 85.5% $21,213 $20,760 No Yes 71 Dropped Yes No 55

*Signicant at 10 percent level **Signicant at 5 percent level ***Signicant at 1 percent level Notes: Statistical signicance is based on a two-tailed test across the added and dropped banks that rejects the null hypothesis of equal means at 10 percent, 5 percent, and 1 percent levels, respectively. Only commercial banks are included in this table. Market characteristics are for 2010. Metropolitan Statistical Area (MSA) location is for the market in which the bank is headquartered. For single-market banks, market characteristics other than MSA location (net migration and population) are for its market in which it is headquartered. For multimarket banks, market characteristics other than MSA location are averages of characteristics of individual markets that the bank may serve, with weights determined by the share of the banks deposits that are located in each of the individual markets. Sources: Census Bureau, Bureau of Economic Analysis, authors calculations.

banks in the exempt sample that added free checking is $22,943, compared with $21,213 in the markets of banks in the exempt sample that dropped free checking. Average deposits per person is slightly higher in markets where banks added free checking than in markets where banks dropped these accounts, but the difference is not statistically signicant. Net migration, a measure for new local demand for checking accounts, is not statistically different in the markets where exempt banks dropped or added free checking.19 The share of working population (ages 18 to 64) or the share of the population with at least a high school education, thought to reect the attractiveness of a market to a bank, also are not statistically different across banks that added or dropped free checking. Financial characteristics. Compared with the exempt banks that dropped free checking, those that added free checking are larger,

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Table 7

FINANCIAL CHARACTERISTICS OF BANKS THAT ADDED OR DROPPED FREE CHECKING Banks in the exempt sample
Added Free Checking Accounts in 2011 Free Checking Accounts in 2012 Number of banks Financial characteristics (averages) Checking account deposits (millions)*** Checking account deposits / total assets*** Total deposits (millions) *** Loans / total assets** Net interest margin $108.5 16.9% $673.0 67.7% 3.65% $22.1 23.9% $75.6 61.9% 3.64% No Yes 71 Dropped Yes No 55

*Signicant at 10 percent level **Signicant at 5 percent level ***Signicant at 1 percent level Notes: Statistical signicance is based on a two-tailed test across the added and dropped banks that rejects the null hypothesis of equal means at 10 percent, 5 percent, and 1 percent levels, respectively. The banks in this table are those that added or dropped free checking from a random sample of 240 exempt banks. Financial characteristics are for year-end 2010. Sources: Call Reports, authors calculations.

depend less on checking accounts to fund their loans, and have a higher proportion of assets in loans (Table 7). Checking account deposits averaged $108.5 million for banks in the exempt sample that added free checking, compared with $22.1 million for banks in the exempt sample that dropped free checking. The ratio of checking deposits-to-total assets is signicantly lower for banks that added free checking (16.9 percent) than for banks in the exempt sample that dropped free checking (23.9 percent). The ratio of loans-to-assets is 67.7 percent for banks that added free checking, signicantly higher than the 61.9 percent for banks in the exempt sample that dropped free checking. Banks that added free checking appear to have had relatively strong demand for loans and relatively low levels of checking account balances. Adding free checking may help such banks fund additional loans. Protability of lending operations, measured by net interest margin, is not statistically different for banks that added or dropped free checking.20 Competitive characteristics. Competitive pressure may also inuence a banks decision to add or drop free checking. One standard measure of competitive pressure is the Herndahl-Hirschman index (HHI),

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which ranges from zero to 10,000 and is larger in a concentrated market where fewer suppliers control output.21 Other relevant measures of competition are a banks market share and the market share of regulated banks in an exempt banks market. Another variable examined in this study indicates whether a bank in the regulated sample dropped free checking in a market that an exempt bank serves, which is particularly relevant to whether an exempt bank reacts strategically to their regulated competitors. The HHI and the market share of banks are typically lower in metropolitan areas compared with nonmetropolitan areas because proportionately larger numbers of banks locate in metropolitan markets. For a clearer view of the effect of competition on decisions to add or drop free checking, the following discussion separates banks in the exempt sample by metropolitan and nonmetropolitan location. Free checking at exempt banks in metropolitan areas. The level of market competition in metropolitan areas appears to have had little inuence on the decision to add or drop free checking. In metropolitan areas, banks in the exempt sample that dropped free checking had an average HHI of 864, signicantly lower than the 1,096 HHI of banks that added free checking (Table 8). Nevertheless, the average HHI for banks adding or dropping free checking is well below the benchmark of 1,800, indicative of competitive markets (U.S. Department of Justice). Banks that added free checking did have a larger presence in their market compared with banks that dropped free checking. Banks that added free checking had a statistically higher market share (2.10 percent) compared with banks that dropped free checking (1.17 percent). In metropolitan areas, exempt bank competition with regulated banks does not appear to inuence the decision to add or drop free checking. The average market share of regulated banks, and the average share of markets where at least one sample regulated bank dropped free checking, are similar across the markets for banks that added or dropped free checking. Free checking at exempt banks in nonmetropolitan areas. The level of market competition in nonmetropolitan areas appears to have inuenced the decision to add or drop free checking. In nonmetropolitan areas, banks in the exempt sample that dropped free checking had an average HHI of 2,728, indicating limited competition, and signicantly

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Table 8

COMPETITIVE CHARACTERISTICS OF BANKS THAT ADDED OR DROPPED FREE CHECKING Banks in the exempt sample
Added Free Checking Accounts in 2011 Free Checking Accounts in 2012 All Banks Number of banks Competitive characteristic (averages) Deposit concentration (HHI)*** Banks market share*** Regulated banks market share*** At least one sample regulated bank in the market dropped free checking** Banks in Metropolitan Locations Number of banks Competitive characteristic (averages) Deposit concentration (HHI) * Banks market share* Regulated banks market share At least one sample regulated bank in the market dropped free checking Banks in Nonmetropolitan Locations Number of banks Competitive characteristic (averages) Deposit concentration (HHI) *** Banks market share** Regulated banks market share* At least one sample regulated bank in the market dropped free checking** 1,937 6.77% 23.3% 69.6% 2,728 14.7% 16.4% 40.6% 23 32 1,096 2.10% 55.7% 79.2% 864 1.17% 53.9% 87.0% 48 23 1,368 3.61% 45.3% 76.1% 1,948 9.05% 32.1% 60.0% 71 55 No Yes Dropped Yes No

*Signicant at 10 percent level **Signicant at 5 percent level ***Signicant at 1 percent level Notes: Statistical signicance is based on a two-tailed test across the added and dropped banks that rejects the null hypothesis of equal means at 10 percent, 5 percent, and 1 percent levels, respectively. Competitive characteristics are for June 2010. For banks that operate in more than one market, the competitive characteristic is a weighted average across the markets with weights equal to the share of the banks deposits in each market. The HHI (Herndahl-Hirschman index) ranges from zero to 10,000 and becomes large when a market is more concentrated (output is controlled by fewer suppliers), is a commonly used measure of market concentration. Sources: FDIC Summary of Deposits, authors calculations.

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higher than the 1,937 HHI of banks that added free checking. In addition, banks that dropped free checking had a larger market share than banks that added free checking. The market share of banks that dropped free checking (14.7 percent) is statistically higher than that of banks that added free checking (6.77 percent). Finally, many of the banks in the exempt sample that added free checking are in direct competition with banks in the regulated sample that dropped free checking, especially in nonmetropolitan markets (Table 8). Banks in the regulated sample that dropped free checking may have motivated exempt competitors in nonmetropolitan areas to add free checking.

Banks in the regulated sample

The competitive characteristics of regulated banks are relevant to the pricing strategies at exempt banks because the banks in the exempt sample that added free checking accounts were relatively larger than other exempt banks. Larger exempt banks may view smaller regulated banks as primary competitors and thus devised pricing strategies that targeted these banks. Table 9 examines this possibility by presenting characteristics of regulated banks that added or dropped free checking accounts in 2012. Market characteristics. Banks in the regulated sample that dropped free checking serve markets have a relatively high net migration (0.47 percent), and a relatively low share of population with at least a high school education compared with the single regulated bank in the sample that added free checking. Financial characteristics. Regulated banks that dropped free checking have relatively low ratios of total loans to assets suggesting less need to attract deposits to fund loans. Competitive characteristics. The banks in the regulated sample that dropped free checking in their markets, have a relatively high share averaging 76.5 percent. Overall, a limited demand for loans and an inability to set checking account prices that effectively attract new customers may have inuenced the decision of some regulated banks to drop free checking.

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Table 9

MARKET, FINANCIAL, AND COMPETITIVE CHARACTERISTICS OF BANKS THAT ADDED OR DROPPED FREE CHECKING Banks in the regulated sample
Added Free Checking Accounts in 2011 Free Checking Accounts in 2012 Number of banks Market characteristics (averages) MSA location Net migration Population aged 18 to 64 Share of population with at least a high school education Per capita income Deposits per person Financial characteristics (averages) Checking account deposits (millions) Checking account deposits / total assets Total deposits (millions) Total loans / assets Net interest margin Competitive characteristics (averages) Banks market share Regulated banks market share Deposit concentration (HHI) 1.0% 72.4% 1,134 1.2% 76.5% 1,322 $8,478 7.8% $85,007 73.1% 3.5% $6,111 8.1% $64,783 64.9% 3.2% 100% 0.048% 62.6% 86.7% $24,677 $22,460 100% 0.47% 63.1% 84.9% $25,201 $33,470 No Yes 1 Dropped Yes No 11

The small sample in this table makes a test of the difference in means inappropriate. An alternative is to test the null hypothesis that the mean of the drop banks equals the sample mean of the single bank that added free checking. At a 10-percent level or less, the null is rejected for net migration, population aged 18 to 64, the share of population with at least a high school education, total loans/assets, and the regulated banks market share. Notes: Market characteristics are for 2010. Financial characteristics are as of year-end 2010. Competitive characteristics are for June 2010. MSA location and competitive characteristics are for the market in which the bank is headquartered. For single-market banks, market characteristics other than MSA location (net migration and population) are for its market in which it is headquartered. For multimarket banks, market characteristics other than MSA location are averages of characteristics of individual markets that the bank may serve, with weights determined by the share of the banks deposits that are located in each of the individual markets. Sources: Census Bureau, Bureau of Economic Analysis, authors calculations.

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Summary of factors affecting checking account pricing

Market, nancial, and competitive characteristics motivated a number of exempt banks to add or drop free checking after regulation of interchange fees on debit cards became effective. Banks in the exempt sample that added free checking tended to be in metropolitan markets with large, afuent populations. These banks appear to have had strong demand for loans and may have added free checking to attract funds for additional lending. They operated in competitive markets where banks in the regulated sample controlled a modest share of the market and were likely to face at least one bank from the regulated sample that dropped free checking. Banks in the exempt sample that dropped free checking tended to be in nonmetropolitan markets, had a relatively large market share and limited competition. Banks in the regulated sample that dropped free checking were in markets with some favorable characteristics but also had limited demand for loans.

CONCLUSION
Interchange fee regulation has led to signicant changes in the extent to which free checking accounts are available to consumers and, in many cases, to changes in the requirements under which conditional free checking accounts are offered. Several key factors appear to have driven banks decisions. Regulation of interchange fees for debit card payments eliminated roughly $8 billion of revenue at regulated commercial banks. Such a large change led many regulated banks to drop free checking. Some exempt institutions may have seen the regulation of interchange fees as an opportunity to drop free checking and earn added revenue from deposit services. However, more exempt banks, particularly larger exempt banksthose with strong loan demand and a need for additional fundingdecided to add free checking. For an average consumer, free checking became more available after interchange fee regulation.22 The footprint of banks offering free accounts rose from 19.4 percent of all checking account balances in 2011 to 21.6 percent in 2012. Elimination of free checking accounts at larger, regulated banks was more than offset by an increase in free checking accounts at smaller, exempt banks. While generally more

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available, a consumer who wants free checking may have to switch to a smaller bank. Changes to another major category of checking account products, conditional free checking, are less clear but are similar to changes in unconditional free checking. Conditional free checking became somewhat more expensive and more complex at banks in the regulated sample but less expensive and less complex at banks in the exempt sample. Some important questions about pricing practices of commercial banks and their checking account products are not addressed in this article and will require additional research. Are the changes to checking account products in 2012 unusually large or are they a normal part of banking? Have changes persisted into 2013? Have they led to appreciable shifts in checking deposit shares among exempt and regulated banks? More broadly, what does a system of interchange fee regulation that splits banks into regulated and exempt groups imply for competition in the banking market? What pricing scheme for checking account services creates the most efcient payments system? Answers to these questions may give policymakers a better understanding of the repercussions of interchange fee regulation in the commercial banking industry.

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APPENDIX 1 DATA AND BANK CHARACTERISTICS Data denitions and sources

The data studied in this article contain observations on commercial banks that have non-zero checking account deposits. The data exclude foreign banking organizations, bankers banks, and other specialty banks that do not engage in consumer debit card services. Sample observations are in two data sets. One data set contains regulated debit card issuers. It is a nonrandom sample drawn from a list of the 100 top debit card issuers based on the dollar value of debit card transactions (Nilson 2010a; 2010b).23 Commercial banks selected were subject to interchange fee caps and were in operation in both 2011 and 2012, leaving 41 observations. The 41 sample banks came from 163 total regulated commercial banks with non-zero checking account balances (Table 1). A second data set contains exempt commercial banks. The data set started with a set of 6,226 commercial banks that led call reports at year-end 2009 and with assets of less than $10 billion. A random sample of these banks initially contained 323 observations. Observations were lost primarily because data on checking account fees and requirements were collected from bank websites, and some smaller banks do not have websites or do not provide account details on their websites.24 As a result, the nal sample included 240 exempt banks. Federal Reserve Board lists determined regulated and exempt status for both data sets. As shown above, smaller banks in nonmetropolitan areas tended to drop free checking accounts. As a result, a lack of data may produce results that to some extent may overstate any reduction in consumers cost of checking account services inferred from the sample of exempt banks.25 The bias would be small if the availability of free checking is measured by the share of checking account deposits in banks that offer free checking because the banks that are lost from the data set are relatively small. Interest-bearing checking accounts were excluded, but changes in these accounts are likely to be similar to noninterest checking accounts.

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On average, interest-bearing checking accounts have higher monthly fees and minimum balances to open and to avoid monthly fees (Federal Reserve Board; Hannan), but interest earnings help offset the cost of these requirements. Finally, data on checking account fees from 1997 to 2002 show that low-balance fees and minimum balances tend to have a stable relationship across noninterest and interest-bearing checking accounts.26 It was expected, therefore, that interchange fee regulation would have a similar effect on debit card services for both noninterest and interest-bearing checking accounts. Collection of data on the terms and conditions of the banks checking account products occurred in March and April 2011, before the nal interchange fee regulation was determined and at least ve months before the regulation became effective. Data collection again occurred from April to June 2012, six months or more after the regulation went into effect. Most banks have more than one checking account product, each with its own features and combination of requirements. As a result, data from some banks included more than one type of checking account. Free accounts, if available, were always coded. Other account offerings at a bank were coded if they were open to a broad set of consumers. Excluded accounts had narrow eligibility requirements, such as those restricted to the elderly, students, or military personnel. Market and competitive characteristics for an exempt bank operating in more than one market were weighted by the share of checking account deposits the bank had in each market. Data on bank nancial and competitive characteristics are from call reports and from the FDIC Summary of Deposits. Data from the call reports are for year-end 2010 and year-end 2011. Summary of deposits data are from June 2011 and June 2012. Market characteristics come from the Census Bureau and the Bureau of Economic Analysis.

Characteristics of population and sample banks

The populations of all regulated and all exempt banks. All regulated banks are much larger and depend to a lesser extent on checking accounts as a source of funds compared with all exempt banks. Checking account deposits average $4,002 million for all regulated banks and $47 million for all exempt banks (Table 1). The ratio of checking

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account deposits to assets averages 9.23 percent at all regulated banks and 22.2 percent at all exempt banks. Compared with all regulated banks, all exempt banks are more protable and are less likely to be in metropolitan areas. Average returns earned on assets are higher at all regulated banks (0.83 percent) than at all exempt banks (0.28 percent). All regulated banks are much more likely to be located in metropolitan areas (93.3 percent) than all exempt banks (50.8 percent). The population and sample of regulated banks. As discussed above, banks in the regulated sample have a higher average total assets and lower return on assets than all regulated banks. Other, relatively minor statistical differences include a lower ratio of checking accounts-toassets (8.35 percent) and a higher rate of metropolitan location (97.6 percent) for banks in the regulated sample compared to all regulated banks (9.23 percent and 93.3 percent) (Table 1). The population and sample of exempt banks. Other than average assets, which, as noted above, are modestly larger at banks in the exempt sample, for other statistical characteristics, banks in the exempt sample and all exempt banks and are similar (Table 1). Both groups of banks, for example, have similar average return on assets (0.36 percent versus 0.28 percent). In addition, distributions of regional location and the deposit size for the exempt sample of banks is representative of the geographic and size distributions for all exempt banks (Charts A1 and A2).

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Chart A1

REGIONAL DISTRIBUTION OF EXEMPT BANKS, 2010

35 30 25 20 15 10 5 New England Middle East Southeast Great Lakes Plains Rocky Southwest Mountains Far West Percent

All exempt banks

Sample exempt banks

Notes: Regions are dened according to the following classication of states by the Bureau of Economic Analysis: New England: Conn., Mass., Maine, N.H., R.I., and Vt.; Middle East: District of Columbia, Del., Md., N.J., N.Y., and Pa.; Southeast: Ala., Ark., Fla., Ga., Ky., La., Miss., N.C., S.C., Tenn., Va., and W.V.; Great Lakes: Ill., Ind., Mich., Ohio, and Wis.; Plains: Iowa, Kan., Minn., Mo., Neb., N.D., and S.D.; Rocky Mountain: Colo., Idaho, Mont., Utah, and Wyo.; Southwest: Ariz., N.M., Okla., and Texas; Far West: Alaska, Calif., Hawaii, Nev., Ore., and Wash. Sources: Call Reports, authors calculations.

Chart A2

DEPOSIT SIZE DISTRIBUTION OF EXEMPT BANKS, 2010

50 40 30 20 10 Percent

$25

$50

$75

$100 $125 $150 $175 $200 $225 $250 $275 $300 Over $300 Millions All exempt banks Sample exempt banks

Source: Call Reports.

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APPENDIX 2 ESTIMATE OF CHECKING ACCOUNT BALANCES IN BANKS THAT OFFER FREE CHECKING
The estimate of checking account balances in banks that offer free checking extrapolates the statistics for the regulated and exempt samples to all banks. The estimate should be accurate for exempt banks because the sample is randomly selected from the all exempt banks. The estimate may be less accurate for regulated banks because the banks in the regulated sample are not selected randomly. However, the magnitude of the error may not be large because the banks in the regulated sample hold 84 percent of checking accounts held at all regulated banks. Moreover, the regulated banks not in the sample are likely to behave like regulated banks in the sample because they are both subject to interchange fee regulation. The estimate starts with the samples of banks. Among banks in the regulated sample, those that offered free checking in 2011 had $116 billion in checking account balances, or a 21.2 percent share of the sample total of $548 billion (Table A1, Panel A). In 2012, the account balances at regulated institutions that offer free checking declined to $74 billion or 10.0 percent of $730 billion in checking account balances. The nal estimate applies the shares for the samples to all banks. All regulated banks in 2011 held $652 billion in checking account balances. Assuming that 21.2 percent of those balances were in banks with free checking, then all regulated banks offering free checking held $138 billion in checking account deposits (Table A1, Panel B). A similar calculation for 2012 provides an estimate of almost $96 billion. The same procedure provides an estimate of account balances in all exempt banks with free checking of $46 billion in 2011 and $182 billion in 2012.

Adjustment for interest payments on business checking accounts

To adjust for the 2011 surge in deposits at regulated banks and keep the ratio of consumer to total deposits closer to historical averages, assume that the growth of deposits at regulated banks over 2011 is equal to that of exempt banks. Exempt bank checking accounts grew

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Table A1

VALUE OF CHECKING ACCOUNTS AT BANKS THAT OFFER FREE CHECKING, 2011-12

A. Banks in the Regulated and Exempt Samples Regulated 2010 All banks (billions) Banks that offer free checking accounts (billions) Share of checking account deposits $548 $116 21.2% 2011 $739 $74 10.0% Exempt 2010 $15.4 $2.4 15.6% 2011 $17.6 $9.8 55.7%

B. Estimate for All Banks Regulated All banks (billions) 2011 $652 Banks that offer free checking accounts (billions) .212 x $652 =$138.0 2012 $958 .1 x $958 =$95.6 Exempt 2011 $294 .156 x $294 =$46 2012 $327 .557 x $327 =$182

C. Estimate for All Banks Adjusted for Interest Payments on Business Checking Accounts Regulated 2010 All banks (billions) Banks that offer free checking accounts (billions) $652 .212 x $652 =$138 2011 1.112*$652 =$725 0.1*$725 =$73 Exempt 2010 $294 .156 x $294 =$46 2011 $327 .557 x $327 =$182

Notes: Offers of free checking accounts are as of spring 2011 and spring 2012. Dollar values are total checking account balances for groups of banks. Aggregate values of checking accounts are as of year-end 2010 and year-end 2011. The bank accounts in this sample have no monthly fees or monthly balance requirement. They may have a minimum opening balance requirement and will also be subject to fees such as for ATM withdrawals or cases of nonsufcient funds. Banks in this table are grouped by whether their debit card interchange fees are regulated or exempt from regulation. The shares in the tables are the percent of the total observations whose debit card interchange fees are either regulated or exempt from regulation. Sources: Call Reports, FDIC Summary of Deposits, authors calculations.

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from $294 in 2010 to $327 in 2011, or 11.2 percent. If regulated bank checking account balances grew at the same rate, then they would have $725 (=1.112*$652) billion in checking account balances in 2011 (Table A1, Panel C). Using the 10 percent of regulated bank balances in banks that offer free checking results in $73 (=0.1*$725) billion in checking account balances in regulated banks offering free checking. For 2011, these results imply that 24.2 (=($73+$182)/ ($725.2+$327)*100) percent of all bank checking account balances were in banks offering free checking. This represents an increase over the 19.4 percent share for 2010 and thus is consistent with results reported above.

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ENDNOTES
The 48-cent interchange fee is based on a $40 payment (Hayashi 2012). Calculations for the interchange fee in 2000, based on interchange rates and the market shares of the four largest debit card networks, result in an average fee of 36 cents, again for a $40 payment. Data on interchange fees and the volume of debit payments are from the American Banker (various issues) and the EFT Data Book (various issues). In 2000, Visa and MasterCard charged lower interchange fees for signature debit payments at grocery stores. Assuming that half of Visa and MasterCards signature debit payments were at grocery stores, the interchange fee on a $40 debit payment was 36 cents. The rate would be higher (lower) if the share of grocery payments is lower (higher) with a potential range of 30 cents to 42 cents. 2 For more on this issue, see Prager and others 2009. Other provisions gave merchants the ability to choose the network that would process the transaction and allowed merchants to provide discount for the use of cash, check, debit cards, or credits cards (Hayashi 2012). 3 A coalition of merchants subsequently led suit against the Federal Reserve Board, arguing that it did not properly follow the specication in the law in setting the cap and that the cap should have been set yet lower. On July 31, 2013, a U.S. District Court ruled in favor of the merchants (Sokou). The Federal Reserve has appealed the decision (Eavis). 4 Wangs estimate is an annualized drop in interchange revenues from the third to the fourth quarter of 2011 for 102 regulated institutions. For comparison, at year-end 2010 the top 100 commercial banks had $202 billion in noninterest income, of which $28 billion was for service charges on deposit accounts (FDIC). 5 In the aftermath of the regulation, the nancial press reported evidence with two points of view. One story reported that Some 93 percent of community banks said they would be required to charge their customers for services that now are free (Digital Transactions News). About the same time, another story had the headline Free Checking Has a Future, Mainly at Small Banks (Garver). Readers need to look behind the headlines of these reports to understand whether the story refers to regulated or exempt banks. Expectations for smaller banks were possibly inuenced by concern over implementation of a single interchange fee. Networks quickly established that they would be able to implement a two-tier interchange system. 6 Use of the terms commercial banks or banks throughout this article refer to depository institutions with commercial bank licenses (or charters) and excludes credit unions and savings and loan institutions. 7 The cost of delivering debit card services is also a nancial characteristic important to banks. Some banks may concentrate on making deposit services more
1

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efcient rather than re-pricing deposit services. A recent survey of debit card issuers found that regulated issuers were more concerned about cost reduction than were exempt issuers (Pulse). Thirty percent of regulated issuers surveyed reduced their costs by ending debit card rewards programs. 8 Regulation Q, which controlled interest rates on deposits, went into effect in 1933. Congress repealed the prohibition of interest rates on consumer accounts in the early 1980s. 9 According to Call Report data, checking deposits at commercial banks increased $344 billion, or 35 percent, in 2011. Interestingly, interest paid on checking deposits declined from $1.34 billion in 2010 to $1.11 billion in 2011, reecting a downward trend in interest rates since 2009. 10 Because larger corporations tend to use the services of larger banks, the surge of checking account balances may have been primarily in banks subject to interchange fee regulation. In fact, checking accounts for all commercial banks increased by $344 billion in 2011 and most of the increase$307 billionoccurred at regulated banks. 11 A third major category of checking accounts is the fee-only account. From 29 percent to 41 percent of banks offered fee-only accounts from 1997 to 2002 (Board of Governors; Hannan). Although fee-only accounts are now less common, interchange fee regulation may have caused a resurgence of these accounts. From 2011 to 2012, availability of fee-only accounts increased from 6 percent to 14 percent of banks in the regulated sample and from 15 percent to 20 percent of banks in the exempt sample. 12 These banks also exclude foreign banking organizations, bankers banks, and other specialty banks that do not engage in debit card services. 13 The list ranks debit card issuers by the value of purchase transactions. Fiftynine banks in the list are either exempt or are not commercial banks and are not in the nal data set. 14 In addition, banks in the regulated sample held 84 percent of the checking account deposits at all regulated banks. 15 The estimate of the checking account balances at all banks that offer free checking shown in Table 3 is calculated by extrapolating the sample results to the population of banks in the United States (details are in Appendix 2). 16 Another natural response of regulated banks to the interchange cap was to reduce rewards programs on debit transactions. In a survey of debit card issuers, Pulse found that 30 percent of regulated issuers had ended rewards programs for debit card transactions. By contrast, among exempt banks in the sample, 10 percent of respondents planned to drop, while 20 percent planned to launch, debit card rewards programs. 17 Banks face barriers to attracting local customers from other banks due to switching costs (Hannan and Adams). Bank customers face the opportunity cost of their time in searching for a new bank and in making new arrangements for payroll deposits or automatic bill payments. Out of pocket costs include new

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checks and possibly new debit cards. If a regulated bank raises its customers cost of checking account services, then an exempt bank may have an opportunity to gain new customers if the customer is willing to absorb switching costs. 18 The designation of statistically different in this section is based on t-tests, chi-square tests, or binomial tests of a null hypothesis that the mean value of a variable across banks that added or dropped free checking is equal. 19 Hannan and Adams nd that migration patterns of banks markets inuence the interest rates banks set for their deposit accounts. 20 Net interest margin = (interest earned on loans interest paid for deposits and other funding) / total loans. 21 The formula for HHI sums the squares of market shares of all competitors in a market and multiplies the result by 10,000. 22 See Hayashi (2013) for a more complete discussion of how the Dodd-Frank Acts provisions on regulated debit card payments affect consumers and merchants. 23 Ofcial lists of regulated and exempt banks were unavailable before mid-2010. 24 Smaller banks generally are less likely to have Internet websites (Sullivan and Wang). Further attrition was related to specialty banks (such as bankers banks) and the need to be in operation for both 2011 and 2012. 25 Small, rural banks are also more likely to drop free checking accounts, so the exempt sample may overstate the availability of free checking at all exempt banks. 26 The ratios of average monthly fees, average minimum balance to open, and average minimum balance to avoid monthly fees for noninterest and interestbearing checking accounts were roughly 83 percent, 25 percent and 50 percent, respectively, from 1997 to 2002 with minor year-to-year uctuations (Board of Governors; Hannan).

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REFERENCES
Association for Financial Professionals. 2010. AFP Electronic Payments: Report of Survey Results, November. Digital Transactions News. 2011. Small Banks Envision a Slew of New and Higher Fees in Durbins Wake, www.digitaltransactions.net/news/story/2924, February 14. Eavis, Peter. 2013. Fed Appeals Rejection of Rule on Debit Card Fees, New York Times, dealbook.nytimes.com/2013/08/21/fed-appeals-rejection-of-rule-ondebit-card-fees/, August 21. Federal Reserve Board. 2003. Annual Report to the Congress on Retail Fees and Services of Depository Institutions, Federal Reserve System, www.federalreserve.gov/boarddocs/ rptcongress/2003fees.pdf. FDIC. 2013. Statistics on Depository Institutions, accessed July 24, 2013, www2. fdic.gov/sdi/. Garver, Rob. 2011. Free Checking Has A Future, Mainly At Small Banks, American Banker, p. 4, March 14. Hannan, Timothy H. 2001. Retail Fees of Depository Institutions, 1997-2001, Federal Reserve Bulletin, pp. 407-413, September. Hannan, Timothy H., and Robert M. Adams. 2011. Consumer Switching Costs and Firm Pricing: Evidence from Bank Pricing of Deposit Accounts, The Journal of Industrial Economics, LIX (2), pp. 296-320, June. Hayashi, Fumiko, Richard J. Sullivan, and Stuart E. Weiner. 2003. A Guide to the ATM and Debit Card Industry, Federal Reserve Bank of Kansas City. _____. 2013. The New Debit Card Regulations: Initial Effects on Merchants, Consumers, and Payment System Efciency, Federal Reserve Bank of Kansas City, Economic Review, First Quarter, pp. 79-115. Nilson Report. 2010a. Top 50 U.S. Debit Card Issuers, Issue 947, April. _____. 2010b. Top 51 to 100 U.S. Debit Card Issuers, Issue 949, May. Prager, Robin A., Mark D. Manuszak, Elizabeth K. Kiser, and Ron Borzekowski. 2009. Interchange Fees and Payment Card Networks: Economics, Industry Developments, and Policy Issues, Federal Reserve Board, FEDS Working Paper 2009-23. Pulse. 2012. Executive Summary, Debit Issuer Study. Sokou, Katerina. 2013. Court Sides With Retailers, Goes Against Fed Rule on Debit Card Fees, Washington Post, articles.washingtonpost.com/2013-07-31/ business/40916047_1_debit-card-fees-merchants-payments-coalition-federalreserve, July 31. Sullivan, Richard. 2012. The Federal Reserves Reduced Role in Retail Payments: Implications for Efciency and Risk, Federal Reserve Bank of Kansas City, Economic Review, 97 (3), Third Quarter, pp. 79-106. Sullivan, Richard, and Wang, Zhu. 2013. Internet Banking: An Exploration in Technology Diffusion and Impact, Federal Reserve Bank of Richmond, Working Paper 13-10, August. U.S. Department of Justice. 2000. Bank Merger Competitive Review. September http://www.justice.gov/atr/ public/guidelines/6472.pdf. Wang, Zhu. 2012. Debit Card Interchange Fee Regulation: Some Assessments and Considerations, Federal Reserve Bank of Richmond, Economic Quarterly, 98 (3), pp. 159-183.