Todd J. Zywicki is Foundation Professor of Law at George Mason University School of Law.
Although the mechanisms vary, legislation pending before Congress on interchange has a basic central purpose—to reduce interchange fees, either indirectly or directly. If adopted, these efforts will likely succeed in their intended goal of reducing interchange fees. But they will also likely have substantial unintended consequences that will prove harmful to consumers and competition and will roll-back the innovation in the credit card market over the past two decades.
Credit cards produce three basic revenue streams for issuers: finance charges (interest on revolving credit), merchant fees, and other fees on cardholders. The ratio among these three streams has remained largely constant for almost two decades. About 70 percent of issuer revenues come from interest paid by cardholders on revolving balances. About 20 percent of revenues are generated by interchange fees. And about 10 percent come from various other fees assessed on cardholders: two decades ago the bulk of this revenue was generated by annual fees, today it is predominantly from behavior-based fees such as over-the-limit fees, late fees, and other similar charges tied to a borrower’s actual behavior. The precise ratios among these three streams varies slightly over time: in recent years, for example, greater use of home equity loans as a source of consumer credit led to a reduction in revolving balances and interest payments and an increase in risk-based fees. At the same time, transactional use of credit cards has risen rapidly, fueled primarily by consumer use of rewards cards, leading to a growth in interchange fee revenue.
So what would happen if retailers get their way and interchange fees were cut by artificial governmental intervention? The mathematics of the situation is inescapable: card issuers would have to increase the revenue generated from consumers from either interest payments or higher penalty fees or reduce the quality of credit cards, such as by reducing customer support or ancillary card benefits. In fact, this is exactly what happened when Australian regulators imposed price caps on interchange fees in 2003: annual fees increased an average of 22% on standard credit cards and annual fees for rewards cards increased by 47%-77%, costing consumers hundreds of millions of dollars in higher annual fees. Card issuers also reduced the generosity of their reward programs by 23 percent.
The credit card system is essentially a closed system: a forced reduction in one stream of revenues generates efforts to substitute other revenue streams. In a competitive market, the losses from one revenue stream have to be made up for somewhere else. Americans have been recently reminded of this lesson, as Congress’s imposition of new limits on certain terms of credit card pricing through the Credit CARD Act over the summer has led to increased interest rates and higher annual fees to offset those restrictions. Because it is more difficult to price risk accurately, issuers have reduced their risk exposure by reducing credit lines and closing accounts. Congress may wail because its legislation failed to repeal the laws of supply and demand, but just as a minimum wage law increases unemployment or rent control creates housing shortages, regulation of some credit terms leads to predictable substitutions for unregulated terms. Direct or indirect price caps on interchange fees would have similar negative consequences.
But while this type of substitution is bad enough for consumers there is an even more important systemic problem. The most important pro-consumer innovation in payment systems of the past two decades has been the general disappearance of annual fees on credit cards (except for rewards cards where the annual fee defrays the cost of program administration). The elimination of annual fees has made it possible for consumers to carry and use multiple cards simultaneously. According to Experian, consumers today have over five credit cards (including retail accounts) on average and over half the population has two credit cards or more. The consequences for consumer choice and competition have been profound—card issuers compete for consumers’ business literally every time they open their wallet to make a purchase. Consumers can and do easily shift balances among different cards depending on which provides the best deal at any given time (according to a survey by ComScore, two-thirds of consumers say that they would consider switching their primary credit card if a better feature were offered). Consumers can also stack credit lines when necessary.
An annual fee is essentially a tax on holding cards. Policies that produced a return of annual fees would strangle this process of competition by making it more expensive for consumers to hold multiple cards, increasing switch costs and dampening competition.
Access to multiple cards (and their credit lines) is particularly important for the three-quarters of independent small businesses that rely on personal credit cards in their business and count on infrequently-used reserve lines of credit to exploit rapidly-developing business opportunities. These reserve lines are especially important today as credit lines have been slashed. Forcing small businesses to pay an annual fee just to maintain access to these reserve credit lines would deter many of them from doing so, stifling entrepreneurship and an economic recovery.
Perverse consequences would likely follow on the issuers’ side of the market as well. Issuers will find it more burdensome to retain customers who pay their bill every month (the lowest-risk group of customers), creating incentives to pursue customers who revolve and the riskiest class of customers who pay behavior-based fees. This substitution will lead to a less-diversified revenue stream (more dependent on non-interchange revenue), making credit card operations riskier and more dependent on the swings in the business cycle. Credit unions and community banks rely especially heavily on interchange revenue as they tend to cater to lower-risk customers that are less prone to revolve balances and pay penalty fees. Reducing revenue from interchange fees would force these issuers to either abandon the credit card market or to pursue a riskier customer base. It is hard to see why Congress would want to adopt policies that punish the most conservative financial institutions, encourage the very risk-seeking behavior that helped to spawn the financial crisis, and encourage a less-diversified and more risky customer base. Yet squeezing interchange fees would do exactly that.
There is no free lunch. In a competitive market, a reduction of the stream of revenues from interchange fees will have to be made up somewhere else. Not only is this term repricing likely to be inefficient by replacing voluntary contract terms with governmentally-created prices but they will likely dampen competition and innovation, thereby harming consumers in the long run.