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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.

What happened in Australia?

Joshua Gans —  8 December 2009

Joshua Gans is the foundation Professor of Management (Information Economics) at the Melbourne Business School, University of Melbourne.

What happens when you take a key price in an industry and cut it in half? For normal markets economists would expect that this would have a dramatic effect on quantity. That, however, was not the experience in Australia when the Reserve Bank of Australian (RBA) used new powers in 2003 to move Visa and MasterCard interchange fees from around 0.95 percent of the value of a transaction to just 0.5 percent. The evidence demonstrates that this change was virtually undetectable in any real variable to do with that industry.

To begin, let’s review the RBA reforms. First, in January 2003, it moved to eliminate the card association’s ‘no surcharge’ rule. Then in October 2003, the new interchange fee came into effect. As this submission outlined, that latter move had an immediate impact on merchants service charges with acquirers passing on the full extent of the interchange fee reduction to retailers. However, there was no impact on the value of credit card purchases, the level of credit card debt or the share of credit versus debit card transactions. Econometric analysis by Melbourne Business School’s Richard Hayes (also appended to that submission) confirmed this. Moreover, that analysis demonstrated that credit card usage did vary with other economic factors including underlying interest rates in the expected direction. Put simply, if we did not know the reforms were actually taking place, you would not be able to observe it in the data.

What was there no impact? There are a couple of possible explanations. First, it may be that the interchange fee was only one of a number of payments between acquirers and issuers and that, unobserved to analysts and the regulator, those payments adjusted to net out the regulated cap. Second, consistent with economic theory, when surcharging is permitted (and it did occur in Australia most notably for online air ticket purchases and phone payments), the interchange fee is neutral (as I will discuss in my next post). That is, the interchange fee reduction causes merchant fees to fall but issuer fees to rise (or loyalty schemes to be curtailed) but otherwise does not impact on the consumer’s choice of payment instrument. However, even if that were the case, it is surprising that there was not some period of adjustment.

The RBA continues to regulate interchange fees but has signaled that it is unlikely to adjust them further. When it comes down to it, by capping the fee the industry has survived without disruption and the RBA has ensured that rising interchange fees and associated problems as has occurred in the US will be avoided. That said, it may interest non-Australians to learn that the previous interchange fee was set in the late 1970s and was never changed despite that dramatic changes in the industry over the next two and a half decades. If there was any country without a credit card anti-trust problem it was probably Australia.

The Australian experience tells us that interventions to regulate interchange fees are probably not as important as ones that might deal with other card association rules or generic competition. But it also tells us that such interventions are unlikely to have dramatic consequences for the industry on the choice of payment instruments.