Interchange fees and other rules

Joshua Gans —  9 December 2009

The GAO report raises concerns about card association the level of interchange fees (that acquirers pay issuers for credit card transactions processed) but also about other card association rules such as the ‘no surcharge rule.’ That rule prevents a merchant who accepts card transactions from charging a ‘point of sale’ premium to consumers who use a card rather than using cash or checks. However, while the report deals with concerns about each issue individually, what is not recognised is that concerns are related. From the perspective of economics, if you deal with no surcharge rules (by eliminating them) there is a diminished and perhaps non-existent case for regulating interchange fees.

To see this, let’s start with the interchange fee concern. A higher fee means a higher charge imposed on merchants. Not surprisingly, they would prefer those charges to be lower and so card associations will recognize that increase interchange fees may decrease card acceptance. But there is a flip-side. Those high interchange fees are an inducement to card issuers to get more cards issued and used. Hence, the proliferation of solicitations and reward programs as interchange fees have risen. Those consumers then become the marketing department of card associations with respect to merchants, putting pressure on them to accept cards despite the high fees.

Now merchants may be able to compensate in highly competitive markets by not accepting cards and offering lower prices to consumers. But if retail markets cannot separate payments with different retailers specializing in card or cash, there is a problem. Retailers who face both cash and card customers must charge them the same amount by virtue of the no surcharge rule. That means that cash customers must effectively cross subsidize the cost to merchants of accepting cards. This leads to numerous inefficiencies including that consumers may be over-selecting expensive cards rather than other instruments. It also leads to what is termed a ‘competitive bottleneck’ whereby competition cannot work to bring value to consumers.

One response to this is to regulate or cap interchange fees. That would mitigate the problem but would also bring with it the costs of regulation. The alternative would be to see if you could restore competitive structure to the payments industry by achieving payment separation another way. Specifically, if surcharges are permitted then merchants will face strong incentives to pass on the direct costs of card usage to card users. Consumers would then have to weigh up whether those additional charges were really worth the other benefits they are getting from card use. But the point is that where previously there was no cost pass through to the right consumers (as opposed to the pool of them), allowing surcharges ensures that happens.

This means that card associations face an additional cost if they increase interchange fees, that consumers will simply not use cards at the point of sale and save their retailers those costs. One might think that this would make the card association’s management and negotiation over interchange fees more complex. However, as Stephen King and I demonstrated in 2003, permitting surcharging makes the interchange fee neutral (see here for other papers on this topic). Put simply, changing it through association choice or through regulation impacts on prices but not on the total level of card transactions or mix of payment instruments. This makes us wonder why the Reserve Bank of Australia chose both to eliminate the no surcharge rule and to regulate interchange fees.

4 responses to Interchange fees and other rules


    In response to Andy S., businesses can indeed drive their costs down in this area greatly if they understand the underlying factors that regulate Interchange and overall processing expense.
    Although Visa & Mastercard and the processing companies that sell these services have devised an increasingly confusing pricing model, if armed with the proper information, businesses can reduce their expense drastically.
    My company, Financial Mitigation Services, serves as an educational company to help businesses work with their current processor to reduce unnecessary fees, excess charges and eliminate billing errors. Our average client saves several thousand dollars per year on this expense and some have cut costs by over 40%.
    While legislation and pressure by trade associations may be helpful in the future, businesses that simply wait for these things to occur to lower their prices are throwing money away every month that they do not need to. Smart business owners are taking action now to reduce these costs.


    Jean M – maybe you could explain how businesses can negotiate and manage all other costs, including rent, labor, health care, fuel, etc., but this is the only expense over which they have no control. Also, it’s not just merchants who are paying interchange, but it’s states and localities, charities accepting online donations, colleges and universities, and anyone else that takes plastic, including politicians accepting donations. See recent article on Oklahoma Univ. trying to save $500K annually in interchange fees:


    The “no surcharge rule” precludes merchants from charging a premium for using credit cards but it DOES NOT preclude them from giving a discount for cash purchases. If merchants are so concerned they should encourage me to use cash. I frequent a store that does this and I use cash there. These fees are a cost of doing business like shipping, postage, telephone service and internet access. Consumers won’t see any decrease in prices from any cap or reduction on interchange fees. That justification is smoke and mirrors and merchants are just jumping on the big bank bashing bandwagon.

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