Interchange Legislation as Counterproductive Consumer Protection Regulation

Cite this Article
Joshua D. Wright, Interchange Legislation as Counterproductive Consumer Protection Regulation, Truth on the Market (December 08, 2009),

This article is a part of the The Law & Economics of Interchange Fees Symposium symposium.

I want to begin with the premise that the legislation pending in Congress, in whatever form is ultimately adopted, will be successful in reducing interchange fees before turning to the question of whether such a reduction can be justified.  Proponents of interchange fee legislation offer two basic defenses of the legislation.  The first is as a statutory substitute for a perceived failure of both markets and competition law to address the “problem” of interchange fees.  Various iterations of this defense of interchange legislation rely on economic arguments that the balance of economic arrangements between merchants and cardholders chosen by Visa or MasterCard over time involves the exercise of market power and reduction of output, or on the general theory that cross-subsidization of credit card users by cash and check customers (whether or not this subsidization is a function of market power) warrants intervention.   Many of the comments in this symposium focus on this dimension of the interchange debate.   It is an important dimension.  I will discuss the proposed legislation from an antitrust economics perspective in my second post.

In this post, however, I’ll focus on interchange legislation as a consumer protection measure.  While defenses of interchange fee legislation often blend competition and consumer protection concerns together, the latter generally involves alleging consumer harm that derives not from collusion or the exercise of market power, but rather unfair or deceptive business practices.  Take, for example, Representative Shuster’s opening statement at the recent House hearings on the Credit Card Interchange Fee Act:

I believe action is needed to help level the playing field between consumers, small businesses, and credit card companies by requiring greater transparency and prohibiting unfair and abusive practices when it comes to interchange fees.

Last summer’s dramatic rise in gas prices was a prime example of inflexibility by credit card companies towards merchants and consumers over the interchange fee. As fuel purchases rose above authorized transaction limits, major card companies reserved the right to repay gasoline merchants a lower price than was actually purchased, particularly on smaller transactions.   I joined with Congressman Welch to introduce H.R. 2382, to curb this type of practice. This legislation focuses heavily on transparency in the hopes of determining whether credit card companies are pursuing anti-competitive practices. It makes Interchange Fees subject to full disclosure and terms and conditions set by credit card companies easily accessible by consumers. It would also prohibit profits from Interchange Fees from being used to subsidize credit card rewards programs. Small businesses, and ultimately consumers, should not be financing perks of luxury card holders.

But will a reduction in interchange fees help consumers?  Economists have been studying two-sided markets since the early 1980s and it turns out one of the most important lessons of this literature (which other contributors to the symposium have already discussed in detail) is that it is very difficult to figure out whether an interchange fee is too high or too low from a consumer welfare perspective.   I do not know whether current interchange fees are socially optimal, or if they’re even close to socially optimal.  There is great reason for skepticism, however, that regulators would be able to do so with any degree of certainty.  One positive feature of H.R. 2382 is that, consistent with the lessons of the economic literature, while it will surely reduce fee levels, it does not attempt to directly engage in specific price regulation.  As my colleague Todd Zywicki notes in his earlier post, however, one highly likely outcome of the legislation is that the mandatory reduction in interchange fees will result in a predictable increase in other fees as credit card companies reprice their services.  Indeed, a second important lesson from the two-sided markets literature is that changes in pricing on one side of the market are often felt on the other.   While one can certainly count the reduction in merchant costs associated with a decline in interchange fees as a benefit to that side of the market, it would be unwise from a consumer protection policy standpoint to assume that these changes represent the free lunch legislators have been looking for after all these years – or that those fees will not simply be reinstated in other guises elsewhere.

In fact, it is relatively straightforward to predict that a reduction in interchange fees will, as in any economic system, be made up for in the form of higher finance charges or other fees imposed on cardholders as happened in Australia where the number of cards with annual fees and the size of those fees increased while benefits offered through reward programs fell.  The effective disappearance of annual fees from the credit card has had a multitude of consumer benefits ranging from the immediate consequence of the reduced cost of credit availability to the indirect benefit of increased competition between issuers who know that consumers are likely to hold several cards at once.    It is no surprise that survey evidence reveals that consumers have particularly strong disdain for annual fees as compared to changes in other terms such as interest rates, late fees, and changes in loyalty programs.

From a consumer protection perspective, one (so far as I can tell) uncontroverted consequence of the legislation will be to reduce consumer access to credit.   Given the tenuous state of the economic recovery, legislation that reduces consumer spending has obvious costs.  Consumer spending is a critical component of any recovery.  As is well known, consumer spending has a multiplier effect, which leads to dramatic economic expansion and the growth in jobs. With an unemployment rate of close to or exceeding 10 percent and weak consumer spending it would seem particularly counterproductive to limit credit availability, especially in light of the highly questionable and transient potential benefits.  The costs of doing so are even more pronounced in the current context when small businesses rely on credit cards to fund business activities and create new jobs.  As David Evans and I point out in arguing against the Consumer Financial Protection Agency Act of 2009, which also purports to grant consumers additional “protections” many of which are of dubious merit, now is not the time for regulation that reduces the availability of consumer credit.   While there are likely other consumer protection measures in the lending industry that could improve consumer welfare,  particularly for the non-bank institutions that virtually all commentators identify as the source of most problem mortgages that led to the financial crisis, interchange regulation cannot plausibly not fall into that category.

There are obvious social costs of adding to the regulatory mix yet another piece of legislation that will quite predictably increase fees to cardholders and lower benefits, thereby reducing credit availability to consumers and small businesses.   Therefore, the burden of justifying interchange legislation is on its proponents to demonstrate its benefits through economically coherent theory as well as systematic evidence that a reduction in interchange fees will be a net gain to consumers in light of these welfare losses through reduced access to credit.  The “consumer protection” arguments often raised against interchange fees as “unfair and abusive” practices do not carry that burden.  The remaining argument is that the cross-subsidy theory warrants intervention on competition policy grounds.  I will discuss that issue in my second post.