Interchange Legislation as Counterproductive Consumer Protection Regulation

Josh Wright —  8 December 2009

Joshua D. Wright is Assistant Professor of Law and George Mason University School of Law.

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.

7 responses to Interchange Legislation as Counterproductive Consumer Protection Regulation


    Prof. Wright wrote “I’m persuaded by the [] view that the honor-all-cards rule is critical to the functioning of the payment system because it ensures the cardholder that her card will be accepted at all merchants participating in the network. If one allows merchants to decide on their own which of the cards within the network they would select, the potential for those individual merchant decisions to damage the reputation of the network would be substantial.”

    That seems rather weakly-founded to me. If a network paired its “honor all cards” rule with a rule that interchange fees would be the same for all cards then merchants could accept all of them without being ripped off by some of them (the difference in interchange fees may be 1% or even more of the transaction value– that’s a lot to a merchant– it may be in the same league as his own margin on the sale!) Of course, that’s not how “honor all cards/no-surcharges” works. The “assurance” to the cardholder is that she can sign up for the most remunerative card-issuer rewards program without worrying that the merchant clobbered with the cost of those “rewards” will balk. That’s not critical to the functioning of the network, it’s only critical to the supracompetitive margins of card issuers.

    As for the potential for merchants to “damage the reputation of the network” by choosing to accept lower- (interchange/ merchant) fee cards and decline higher-fee cards, we have empirical reason to believe this is (a) not damaging at all, and (b) pro-competitive. Right now merchants decide whether to accept Visa, MasterCard, American-Express, and various other cards. Merchants often refuse American Express cards because the fees are much higher than for most (though not all) Visa or MC cards (network rules forbid surcharging).

    Does this “damage” American Express’ reputation? No. Cardholders understand the economic tradeoffs well and adjust the mix of cards they carry to meet their desires for “rewards” and their desires to use cards with some merchants who don’t want to price those rewards into their goods and services.

    AmEx stays in business because merchants and cardholders agree that it provides the right mix of benefits to all parties for some transactions (it helps that AmEx rewards transfer some surplus from businesses to cardholders effectively (if not legally) tax-free through “expense reimbursements” paying inflated prices which in turn support “rewards”).

    Merchants who don’t see a benefit from AmEx don’t accept those cards. AmEx and the others (Visa, MC, etc.) *compete* for merchants; all of them offer co-op advertising deals and special fee arrangements to merchants with clout (either cachet or volume).

    If the big networks like Visa and MC were forced to expose their member card-issuers to competition over “interchange” fees, then on the experience of AmEx competing with the other networks, I would expect such competition to result in a more efficient market overall. Immediately after a reform of the rules, cardholders trained in the “honor all cards/no-surcharges” era might be briefly discomfited by some merchants rejecting or surcharging some (greedy) cards, but that would be a minor transition problem– such customers would call their issuers (or perhaps other issuers) and get lower-fee cards to carry. The lower-fee cards might come with fewer “rewards” but obviously, consumers in the aggregate could not lose by that.[1]

    Merchants could choose how many sales, if any, to forego by refusing or surcharging some cards. They might waive surcharges for good customers, or on high-margin sales, or “just this once, but next time bring a different card.” It doesn’t matter– competition would sort that out fairly quickly. Banks could compete to offer more widely-accepted (read: cheaper) cards as well as cards with fancier loyalty programs. I am quite confident of that, because Visa/MC do that now, competing with AmEx! (Remember those old Visa ads? “Bring your Visa card, because the Olympics don’t take American Express.” That could turn into “bring your XYZ Bank Visa card, because department stores don’t take Citibank.”)

    [1] Certainly the distribution of “rewards” benefits and burdens among cardholders would shift.


    An important adjunct to Josh’s point is that, as interchange fees decrease and annual fees increase correspondingly, there will be a decrease in the number of cards in anyone’s wallet at any given time. This ability to choose between cards at the POS is in part a function of low interchange fees. Raise those fees and while it becomes more important for cardholders to hold more than one card, it also becomes less likely.


    The fact that most cardholders have several cards might influence the magnitude of the efficiency gains from the honor all cards rule, i.e. the higher the number of cards the consumer carries in its wallet the more likely that he has one that will work if the merchant rejects some of them. But that’s not the same as saying there are not efficiencies associated with the rule. Or there are no costs imposed on consumers for using the network under such conditions relative to the world where all cards are accepted. And its not the same as saying that those gains are small. Just that those losses would be smaller than they would be if consumers didn’t carry a bunch of cards (including some low interchange cards). We can certainly debate the magnitude of these gains. But I am comfortable sticking to the modest claim here that whether or not the benefits of such a rule have fallen over time, they exist, while evidence of consumer gains from eliminating such a rule (or reducing interchange) are harder to pin down empirically.

    I think its also important to note here that the increase interchange fees occurred at least in part because of an increase in payment card system competition for issuers as the issuers developed methods to increase cardholder loyalty. With increased cardholder loyalty came greater sensitivity to interchange fee differences from issuers (because they could now shift customers from one card to another while losing fewer sales) and more intense competition from payment systems and higher interchange fees. Complaints about the particular margins on which this competition took place sound much more like complaints about the competitive process than they do like traditional antitrust concerns.


    I agree with you that the honor-all-cards rule would be more justified if it was necessary to make the system work. But in a world in which the typical cardholder has several cards in the wallet, and in which few cardholders have only high-interchange cards in their wallet, then it seems pretty unlikely to me that the bundling of the two very differently priced products is “critical” to the efficient functioning of the system. Remember, these price disparities first appeared only after the settlement in the debit-card litigation gave the networks a federal-court approved right to force merchants to accept the bundling.


    Thanks for the comment Ronald. I’ve got two general responses. The first is that the direction that one believes the tying rule cuts for this analysis will depend critically on whether one thinks its economic function is critical to the efficient functioning of the payment system or a mechanism to extract monopoly rents.

    I’m persuaded by the former view that the honor-all-cards rule is critical to the functioning of the payment system because it ensures the cardholder that her card will be accepted at all merchants participating in the network. If one allows merchants to decide on their own which of the cards within the network they would select, the potential for those individual merchant decisions to damage the reputation of the network would be substantial.

    The second point is that, while one must recognize that pro-competitive function of the honor all cards rule in payment systems in the overall balancing, it does necessarily follow that (as you suggest in your comment) the interchange fees are at optimal levels. I agree with you there. But I do not think it changes the analysis in my post that regulators do not have a useful baseline for determining optimal fees. In the absence of clear efficiency gains and the risk of significant efficiency and consumer welfare losses, I believe the “first do no harm” principle is a wise guide to policy whether or not we have any evidence that current fees are “optimal” in the blackboard economic sense.


    You probably are right that regulators have no useful baseline to set a properly “reduced” interchange fee. But how does the two-sided markets analysis work out in a case where the price level is maintained by tying: if we knew that many merchants would refuse to accept Visa Signature and World MasterCard products if they could unbundle those products from the standard Visa and MasterCard products what makes us think the current interchange fees for those products are at the “correct” level?

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    […] Costs of Fraud.Bob Chakravorti on The Merchants' Insincere Concern About Cross-Consumer Subsidies.Geoffrey Manne on Interchange Legislation as Counterproductive Consumer Protection Regulation.Josh on Interchange Legislation as Counterproductive Consumer Protection Regulation.Ronald J. Mann […]