A provision within the financial reform bill that would regulate debit card transaction fees could be postponed by a year or two following fierce objections from banks. Specifically, banks large and small are objecting to a Fed proposal to limit what are known as interchange fees — the fees they collect from merchants every time a customer uses a bank-issued debit card to make a purchase.

Lawmakers in both houses of Congress last week drafted legislation to postpone writing new debit interchange rules for one to two years. According to Dodd-Frank, the rules were supposed to be finalized by April 21 and to go into effect by July 21.

Consumer groups have decried the delay, saying it would postpone much-needed reform to a system that is “uncompetitive, non-transparent and harmful to consumers” [PDF]. At the same time, these groups voiced concerns that if interchange reform passes, banks will levy other charges on consumers — something many banks have warned they may do.

Given the controversy, we’re taking a closer look at how interchange works and what’s at stake for banks, for businesses and for consumers.

How Interchange Works

Many consumers are only vaguely aware of the existence of the interchange fees—or “swipe fees”—but they’re still paying for them because the costs are ultimately passed on to consumers in the form of higher retail prices. The fees often cause retailers to offer discounts for cash or set minimums for credit and debit purchases.

Aside from the argument that paying with plastic is convenient for both consumers and merchants, the justification for interchange fees is partly that banks assume some risk in these transactions, particularly with credit purchases. But because debit transactions are simpler—a matter of moving money from one account to another—some have argued that debit interchange fees are unjustifiably high.

The Dodd-Frank financial reform bill takes aim at only these debit interchange fees. It tasked the Federal Reserve with adopting standards to determine whether interchange fees are “reasonable and proportional” to the cost of processing the transaction.

What the Fed came up with was a plan [PDF] to cap debit interchange fees at 12 cents per transaction—a proposal that banks appear to uniformly hate. They currently get about 1 to 2 percent of each debit transaction, which averages out to about 44 cents.

The exact numbers are squishy here and are negotiated between merchants and payment networks like Visa and Mastercard, but generally fees for credit cards are higher than for debit cards—and they get even higher if the cards have fancy reward programs. (The card networks also collect their own “network fees” from merchants, which they keep, but as the New York Times has noted, those fees are smaller, and they’re not particularly controversial.)

Some have pointed out that this means merchants—and customers, in the form of higher prices—essentially subsidize the purchases and perks of card-users. According to an analysis released last year [PDF] by the Boston Federal Reserve, such subsidies average more than $1,000 for card-using households each year.

It’s also worth noting that debit card payments with PIN numbers are less costly for merchants than debit card payments with signatures. The larger fees are why some banks have tried to encourage customers to use signature debit instead of entering their PINs, even though PIN transactions are more secure and cost businesses less.

The debit transaction themselves, as the Washington Post has pointed out, only cost a few pennies each to conduct if you don’t count the infrastructure costs. (As it happens, the Fed isn’t counting infrastructure costs in calculating the fee cap. Costs like network connectivity or overhead costs, “cannot be attributed to any particular transaction, given that they could not be avoided if any particular transaction did not occur,” Federal Reserve Governor Sarah Bloom Raskin testified last month.)

As Reuters columnist Antony Currie points out in his handy FAQ, Visa Europe has capped its debit card interchange fees at 0.2 percent of each transaction, and U.S. interchange rates currently average about six times that.

Billions at Stake for Banks, Which in Turn Warn of Impact on Consumers

In their lobbying pitches to regulators, banks and merchants have both argued their positions by citing the effect of the proposed rule on consumers.

“The concerns that we have raised revolve around how this is going to impact basic free checking accounts, particularly for low-income Americans,” a spokesman for the American Bankers Association recently told the St. Petersburg Times.

The banks’ professed concern for the low-income is interesting: As financial blogger Mike Konczal has pointed out, there really is no such thing as “free” checking. There’s just “a monthly fee that is waived if you do certain things” and meet certain requirements, like a direct deposit or minimum balance—which low-income people are the least likely to be able to meet, anyway.

The big banks—whose cards account for 80 percent of debit transactions—stand to lose billions in revenue each year. (The amount has been pegged at anywhere from $12 billion to $20 billion.) The New York Times points out that debit transactions are forecast to overtake cash purchases by 2012.

Many banks say they will be forced to cut rewards programs or eliminate services such as free checking. Some, like JPMorgan Chase, are even considering putting a cap on the size of debit purchases.

Despite an Exemption, Community Banks Say They’re Concerned Too

Big banks aren’t the only ones complaining. Even though the Fed’s proposal exempts banks with less than $10 billion in assets from the interchange cap, and Visa has said it will implement a two-tier system to protect small banks, community banks have argued that the exemption won’t work because merchants will discriminate and refuse to accept their cards, forcing them to lower their fees in order to remain competitive with the big banks.

“This rule will unquestionably lead to more consumer fees, fewer product choices and greater consumer confusion regarding card acceptance,” the trade group Independent Community Bankers of America has stated.

Fed Chairman Ben Bernanke has said “it is possible” that the exemption won’t work, but Sen. Richard Durbin—who proposed the community bank exemption in the Dodd-Frank law—has said Bernanke is wrong. He pointed to “very strong” rules by card companies that bar merchants from refusing cards within their networks.

Some advocates of interchange fee reform, including Durbin, suspect the bigger banks are manipulating the community banks and credit unions to raise their objections. Durbin called it “one of the most active lobbying efforts I've ever seen."

“The fact is credit unions and smaller banks are just more effective spokesmen on this issue right now,” Politico quoted an anonymous executive at a large bank as saying.

Retailers Argue Current System Gives Banks and Card Networks Too Much Power

The National Retail Federation, a trade group for retailers, has argued that the current payment system is not competitive and that Visa and Mastercard—the two major networks in the debit world—have too much power to control and inflate fees.

And while banks have argued that competition between Visa and Mastercard is strong and enables merchants to apply pressure to drive down fees, a piece in the New York Times from January suggests the competition actually goes the other way: Payment networks compete to keep the banks happy with higher fees. From the Times:

As debit cards became the preferred plastic in American wallets, Visa has turned its attention to PIN debit too and increased its market share even more. And it has succeeded—not by lowering the fees that merchants pay, but often by pushing them up, making its bank customers happier.

In an effort to catch up, MasterCard and other rivals eventually raised fees on debit cards too, sometimes higher than Visa, to try to woo bank customers back.

Even the federal government—which some have argued should be able to negotiate rock-bottom interchange fees because the risk the banks front for the feds is next to nothing—has had trouble controlling the millions it pays in fees deducted from debit and credit transactions.

“Some federal entities have attempted to negotiate with the card networks to lower interchange rates applicable to their transactions, but with limited success,” read a 2010 Government Accountability Office report. An earlier GAO report found that non-government merchants also had little success.

Merchants Promise They’ll Pass Savings On to Consumers

Small business owners and major retailers have argued that the Fed plan to cap interchange fees is a pro-consumer move, according to Bloomberg, which reported that about 170 small business owners recently flew to D.C. to relay that message.

Several retailers supporting the cap have promised to share their savings. Here’s the Wall Street Journal:

Retailers maintain that most of their fee-cut windfall would be shared with customers. Home Depot, among those lobbying most aggressively for the cuts, said: "Any relief as it pertains to these fees will give the Home Depot the ability to reduce our cost of doing business. ... Such benefits are likely to include lower prices and investment in the business to better serve customers."

There’s nothing in the proposed rule or in Dodd-Frank, however, to ensure that savings are passed on.

A 2009 government report found that even if interchange fees were to be capped, “the ability of merchants to pass on their savings from lower interchange fees would depend heavily on the respective merchants’ size and market share.” [PDF]

The Fight Continues as Lawmakers Consider a Time-Out

In addition to heavy lobbying on Capitol Hill, banks have taken their pleas directly to consumers by setting a website called Don’t Make Us Pay. It warns consumers that “Congress and the Federal Reserve want to force YOU to pay more to use your debit card.”

“NO MORE REWARDS,” “MORE RESTRICTIONS,” “HIGHER FEES,” “END OF FREE CHECKING,” the website warns. “TELL CONGRESS NO!” (Hat tip to Slate for flagging the site.)

The group behind the website is the Electronic Payments Coalition, whose members include the major banks, bank trade groups, and both Visa and Mastercard. Politico reported that the coalition has also been running television ads and placing ads in D.C. subway cars.

The Hill reported that merchant groups have also taken out ads to promote interchange fees, though between banks and merchants, NPR notes that banks have the edge in the fight based on financial heft:

Commercial banks, credit unions, and Visa and MasterCard—who run the biggest debit card networks—spent a combined $75 million lobbying on all issues in Washington last year, nearly double the retail industry's $40 million, according to the nonpartisan Center for Responsive Politics, which tracks such spending.

Financial firms’ campaign contributions during the 2009-2010 cycle also were twice those of merchants, according to NPR.