Archives For interchange and credit cards symposium

Two related items from ICLE:

As regular readers know, interchange fees are a frequent topic of conversation around the blog.  Taking the conversation from the ether to the real world, ICLE has funded a white paper and is putting on a conference next week on the topic.  The conference, in fact, grows out of the successful online symposium we held here at Truth on the Market a few months ago.  An e-book/pdf version of the posts and comments from that sympoisum can be downloaded here, by the way.  A few of the participants from the symposium will be participating in the conference, as well (more below).

The paper, by Todd Zywicki (ICLE Senior Fellow and Foundation Professor of Law at George Mason University School of Law), is entitled, “The Economics of Payment Card Interchange Fees and the Limits of Regulation.”

The timing of the paper’s release couldn’t be more fortuitous, as Congress reconvenes next week and begins to confer over the language of the Durbin Amendment to the “Restoring American Financial Stability Act of 2010.”  The Durbin Amendment would impose price controls on debit card interchange fees and would restrict the use by credit and debit card networks of certain network rules.  As Todd described it recently in a Washington Times op-ed:

Late in the Senate’s proceedings on the financial regulatory reform bill, the Senate adopted – with no hearings and minimal debate – a controversial provision proposed by Sen. Richard Durbin, Illinois Democrat, that imposes price controls on interchange fees for debit and prepaid cards. The amendment also allows merchants to override several rules of payment card networks that currently protect consumers from abusive practicesby merchants. While big-box merchants and convenience stores are declaring this a victory against the financial services industry, if the amendment survives in conference committee, consumers and small banks will be the real losers.

The paper, although focused most heavily on credit card interchange fees (and the attendant complexity of credit card markets more generally) has important implications for the debate over the Durbin Amendment.  As the paper’s abstract explains:

Fresh off of the most substantial national liquidity crisis of the last generation and the enactment of sweeping credit card regulation in the form of the Credit CARD Act, Congress continues to deliberate, with a continuing drumbeat of support from lobbyists, a set of new regulations for credit card companies. These proposals, offered in the name of consumer protection, seek to constrain the setting of “interchange fees”—transaction charges integral to payment card systems—through a range of proposed political interventions. This article identifies both the theoretical and actual failings of such regulation. Payment cards are a secure, inexpensive, welfare-increasing payment mechanism largely unlike any other in history. Rather than increasing consumer welfare in any meaningful sense, interchange fee legislation represents an attempt by some merchants to shift costs away from their businesses and onto card issuing banks and cardholders. In particular, bank-issued credit cards offer a dramatic improvement in the efficiency and availability of consumer credit by shifting credit risk from merchants onto banks in exchange for the cost of the interchange fee—currently averaging less than 2% of purchase value. Merchants’ efforts to cabin these fees would harm not only consumers but also the merchants themselves as commerce would depend more heavily on less-efficient paper-based payment systems. The consequence of interchange fee legislation, as Australia’s experiment with such regulation demonstrates, would be reduced access to credit, higher interest rates for consumers, and the return of the much-loathed annual fee for credit cards. Interchange fee regulation threatens to constrain credit for consumers and small businesses as the American economy begins to convalesce from a serious “credit crunch,” and should be accordingly rejected.

The paper presents a detailed analysis of the economics of payment card networks and the implications for the various participants in those networks–from consumers to banks to merchants, among others–of political intervention into the setting of the interchange fee.

Please click on the link to download the paper:

Todd J. Zywicki, “The Economics of Payment Card Interchange Fees and the Limits of Regulation.”

Coinciding with the release of the paper, ICLE, in conjunction with George Mason University’s Mercatus Center, will be hosting a conference in Washington, DC, next week on the interchange fee debate.  For more information on the conference and to register, please click here.  The conference, to be held on June 9th from 8:30 am to 1:00 pm at the Willard InterContinental Hotel, will cover both the politics and regulation of interchange fees, as well as the underlying economics of card networks and the place of the interchange fee in those networks.

Conference Speakers include:

Thomas Brown, O’Melveny & Myers LLP

Sujit Chakravorti, Federal Reserve Bank of Chicago

Thomas Durkin, Former Senior Economist, Federal Reserve Board

Mike Konczal, Roosevelt Institute

Geoffrey Manne, International Center for Law and Economics

Megan McArdle, Atlantic Monthly

Tim Muris, former Chairman, Federal Trade Commission

Felix Salmon, Reuters

Steven Semeraro, Thomas Jefferson University

Fred Smith, Competitive Enterprise Institute

Joshua Wright, George Mason University Law School and ICLE

Todd Zywicki, George Mason University Law School, Mercatus and ICLE

We hope to see you there

iclelogoOver at the International Center for Law and Economics website we’ve posted a link to a pdf e-book version of the collected content (including both posts and comments) from our recent “Interchange Fees and the Law and Economics of Credit Cards” symposium.  Head on over and download a copy if you’re interested in a dead tree version of the symposium.

Symposium Wrap Up

Geoffrey Manne —  10 December 2009

Thanks to all of our participants and readers for the blog symposium–both the posts and the comments were engaging and thoughtful, and I hope these entries will be helpful in the ongoing debate over credit cards and interchange fees.

A concluding point or two:

Credit card networks are incredibly complex, and no one fully understands the full consequences of tinkering with these markets.  The best empirical evidence we have is difficult to interpret, and the broad interactions among the parts of the credit card system, between cards and other payment systems, and in the macro-economy more generally are simply unknown:  Richard’s do no harm principle seems like the strongest conclusion in this debate.

At worst, theory and empirical evidence suggest that lowering interchange fees does nothing to help consumers, and in fact harms them by raising annual fees and thus again by limiting competition among cards at the point of sale.  Perhaps there is some policy reason why we would want to help merchants at the expense of consumers, but the issue, often framed as merchants and consumers against banks and card networks, really seems to be merchants against consumers.  At best, we have no idea what the full social implications of capping interchange fees would be–but there is still a conflict between merchant and consumer interests, and we should be wary.

As I read the comments and posts in this debate, essentially all of us agree that, at minimum, there is a potential for consumer harm from government intervention in these markets.  Certainly all of us engaged in this discussion–even those with a more “pro-regulatory” bent–are far more circumspect about the prospects for positive social welfare effects and effects on consumers in particular than are the proponents of regulation.  I do wish our system limited the political salience of regulatory initiatives unsupported by evidence–the burden should be on the proponents of intervention to demonstrate affirmatively that regulation will likely have net positive effect.  Here, this is simply not the case.

As is so often the case, Richard has the last word:

The clear upshot is that it is difficult through informed speculation to identify all the collateral consequences of running a credit card system, both positive and negative.  The only sure piece of data that we have is that credit transactions have done far better than cash and checks, even if they are losing ground to the next generation of payment systems that rely on cell phones and other technologies that are untied to the now ubiquitous magnetic strip.  These dynamic changes could easily force down interchange prices without the need for administrative proceedings.

The hard institutional question therefore is why concentrate major reforms on the interchange fees when all these other components must be added into the mix.  On this question, priors really matter. And after reading the assembled posts, my own view is that technological innovation is a far more important driver of improvements than partial fine-tuning of the current system, whatever its flaws.

In one sense, therefore, we, the members of this blog-fest, may well be part of the problem.  By putting one part of a complex payment industry under a microscope we divert resources from cost reduction measures that have unambiguously positive effects.  How large a cost is this?  Frankly, no one knows.  But given the risks of error in implementation, the best response still seems to be, play for the next big breakthrough, and in the short run, leave well enough alone.

Thanks once again to all of our great participants, and to our readers.  The full set of posts and comments from the symposium are available by clicking on the “credit card symposium” link on the right side of the TOTM page.

I have now had a chance to review the excellent posts on the second day, all of which have a common flavor.  They expand the universe of relative considerations that need to be taken into account to decide whether imposing caps on interchange fees enhances or reduces overall social welfare.  The narrow perspective on this issue, which is difficult enough, is to master the dynamics of two-sided markets to figure out where the fixed costs of running the overall system should be allocated.

That model assumes that the credit card business operates in isolation from all other payment systems present and future.  Its effort is to run an efficient allocation of costs in the face of the famous marginal cost controversy that dates back to the 1940s.  Unless there is some outside subsidy all relevant players cannot be allowed to pay only marginal cost.  Yet to put in the subsidy is to create a tax distortion in some unrelated market whose welfare consequences are virtually impossible to track, given the difficulty that arises in discovery of the incidence of the tax as it works its way through the economy.  We are therefore necessarily in the world of second-best even on the simplest possible analysis.

Unfortunately, that simple analysis leaves a lot out of the equation.  One key issue is the competition that credit cards have with noncredit card systems, each of which may have built in distortions of their own.  We know that the United States has to print and police the use of cash. We also know that it can disappear from company coffers into the hands of dishonest employees.  It can be lost.  It can be stolen.  It can get waterlogged.  It can be deposited in the wrong account by accident.  Credit cards reduce these costs, and they do so arguably in a more efficient form than the use of checks, which of course clear at par, which means that the cost of interchange is borne by general tax revenues, with the usual set of static distortions. It also creates dynamic distortions because the want of price signals between the players makes it harder to introduce innovation into that space on such critical matters as error control, even if it would result in higher level of reliability in transactions.

In addition, it is also important to consider the other benefits that can arise with the use of credit card payments, one of which is the ability to key in all relevant data from a transaction at once.  Quite simply it may well be easier to link in inventory control, for example,  with a credit card system than it is with a cash or checking system. And it may speed up the rate of transactions so as to reduce the length of queues that are so important in many retail operations.

The clear upshot is that it is difficult through informed speculation to identify all the collateral consequences of running a credit card system, both positive and negative.  The only sure piece of data that we have is that credit transactions have done far better than cash and checks, even if they are losing ground to the next generation of payment systems that rely on cell phones and other technologies that are untied to the now ubiquitous magnetic strip.  These dynamic changes could easily force down interchange prices without the need for administrative proceedings.

The hard institutional question therefore is why concentrate major reforms on the interchange fees when all these other components must be added into the mix.  On this question, priors really matter. And after reading the assembled posts, my own view is that technological innovation is a far more important driver of improvements than partial fine-tuning of the current system, whatever its flaws.

In one sense, therefore, we, the members of this blog-fest, may well be part of the problem.  By putting one part of a complex payment industry under a microscope we divert resources from cost reduction measures that have unambiguously positive effects.  How large a cost is this?  Frankly, no one knows.  But given the risks of error in implementation, the best response still seems to be, play for the next big breakthrough, and in the short run, leave well enough alone.

In my first post I discussed the potential for interchange legislation from a consumer protection perspective, that is, would the combination of disclosure requirements coupled with a reduction of interchange fees be likely to improve consumer welfare.   I concluded that from the consumer protection perspective, the case for interchange legislation was weak.  I noted that a highly likely consequence of a direct or indirect reduction in interchange would result in an increase in the cost of credit to consumers (higher finance charges, other fees, annual fees) or a reduction of consumer benefits (loyalty and rewards programs).  The significant risk of a reduction of consumer access to credit, especially given the tenuous state of the economic recovery and the critical role of consumer spending in generating economic expansion and jobs, imposes a significant risk of consumer and social losses without strong evidence of offsetting consumer protection value.  However, consumer protection is not the only possible defense of such legislation.  This post will focus on defense of interchange legislation from a competition policy perspective.

As the commentators in this symposium suggest, as does the long and storied antitrust history of Visa and MasterCard, the more conventional story is that interchange fees are the product of a market power and the lack of competition between payment card systems.   Much of the discussion here has followed that general framework and focuses on the “cross-subsidy” question and the role of interchange legislation in increasing efficiency by reducing “usage” externalities.   The essence of this argument is that interchange fees should be regulated or eliminated in order to avoid cross-subsidization of payment card users by those using cash or checks (but see Ron Mann’s post here, focusing on the subsidy running from high interchange credit products to low interchange debit transactions).  So far, the symposium contributors have been largely skeptical of this defense.  For example, my colleague Todd Zywicki notes;

So it may be theoretically possible to imagine that credit cards are overused as a transaction medium.  On the other hand, it may also be possible that consumers underuse electronic payments because they don’t consider the social benefits of electronic payments, such as increasing efficiency, tax compliance, reduced risk of theft (and the police force and judicial system that accompany that)—in which case, it is possible that credit cards should be subsidized, not taxed.  Finally, it seems at least as plausible (probably more so) that consumers overuse cash and checks because those payment systems are subsidized by the government or that some of their costs are externalized, thus consumers don’t pay their full price.

Tom Brown and Tim Muris argue that the objection to cross-subsidies is overdone, emphasizing the ubiquity of such cross-subsidies and noting that the shift toward electronic payments render this objection largely moot:

At the outset, we note that discount fees, unlike interchange, are a feature of virtually all private payment instruments.  Thus, if there is something to the notion that discount fees tax other forms of payment, then the criticism applies as much to American Express and Discover as it does to MasterCard and Visa.  In our view, however, although this criticism is oft repeated, repetition obscures a number of problems.

First, cross-subsidies are ubiquitous in any complex economy.  Consumers receive free refills on drinks in restaurants, free parking at shopping malls, goods below cost in supermarkets (via loss leaders), relatively inexpensive newspapers because advertisers pay most of the costs, and many similar benefits.  To bring buyers and sellers together through such intermediaries as newspapers, supermarkets, and credit cards, one side frequently receives inducements to participate.  These inducements help maximize the joint value of the ultimate transaction for the parties.  Rather than an inefficient “subsidy,” these inducements are the lubricant necessary to make the economic machine work at its best.

I agree with these commentators that the cross-subsidy “problem” does not warrant a regulatory fix.  But I have a slightly different, and more antitrust-centric perspective.  Brown and Muris note the ubiquity of cross-subsidies in restaurants, supermarkets, and shopping malls.  These are just examples.  Cross-subsidization would occur not only in these settings, and in settings where firms do not plausibly have market power, but would also occur in closed-loop systems that do not use interchange fees, suggesting that this criticism has more to do with the necessity of balancing in two-sided markets rather than interchange per se.  But the important point from an antitrust perspective is that cross-subsidization is a normal and healthy part of the competitive process that generates substantial benefits for consumers.  The normal competitive process frequently does not result in customers being charged for all of the costs associated with their purchases.  Consumers face such cross-subsidies every time they go to Starbucks for their caffeine fix or an all you can eat buffet.  Some consumers are very sensitive to which products are allocated to the eye level shelf space in the grocery store, while others will purchase their favorite product regardless of where it is put on the shelf.   The very idea of promotion is to target what amount to effective discounts at marginal consumers rather than the infra-marginal ones.  See generally, Benjamin Klein, Kevin Murphy, Andres Lerner and Lacey Plache, Competition in Two Sided Markets: The Antitrust Economics of Payment Card Interchange Fees, 73 Antitrust L.J. 571 (2005).

Understanding the nature of promotion, and therefore cross-subsidization, as a part of the normal competitive process offers a new perspective on the potential for interchange legislation as an antitrust remedy.  Competition in highly competitive markets, such as grocery retail, results in supermarkets competing by offering various promotional services to marginal consumers.  Sometimes this competition results in free parking that some consumers use but others pay for, sometimes it results in dimensions of non-price competition (like offering a deli or keeping the store clean) that some consumers value more than others.  Competition between supermarkets to shift sales from these marginal consumers generate largely inter-retailer effects, but that cannot be said to be “inefficient” in any meaningful way.  This form of competition is essential to the competitive process.  Consider the interchange legislation in this light.  Do we, in response to supermarket competition resulting in “usage externalities” call for legislation that would allow the supermarkets to collude?  Of course not.  From a competition perspective, the very idea of replicating the collusive outcome for merchants and allowing a coordinated reduction in competition on the grounds that it would reduce cross-subsidies or costs wouldn’t make economic sense.  But notice that collusion between supermarkets to refuse to offer free parking, clean stores, or other promotional services would surely reduce the costs to the retailers in the same way that interchange would result in a reduction of costs to the merchants.

One possible explanation of our tolerance of these arguments is a failure to understand that, like in the case of supermarkets, competition between merchants on the acceptance of payment cards is a normal part of the competitive process.  But there is another possible and more plausible argument: countervailing power.  In other words, one could argue that legislation to allow collective monopsony conduct is appropriate to offset monopoly power (see, e.g., Steve Salop’s recent guest post here at TOTM on this issue in a different context).  Whether or not this justification is persuasive depends on the degree to which payment system market power explains interchange fees.  As it turns out, there is not compelling evidence that this is the case.  For example, consider that regulation reducing the interchange fees for open loop systems (and reducing their ability to balance both sides of the market) results in a shift of total credit purchase volume toward closed loop systems.  The loss in share that MC and Visa experienced in reaction to the Australian regulation suggests that interchange levels were not supra-competitive before the regulation.  Further, as Klein et al (2005) suggest, the time series evidence also casts doubt over the claim that market power explains interchange fee levels since fees were falling from 1977 to 91 while the importance of the payment systems was growing, and that fees remained lower in 2005 than they were in 1971.  In short, interchange fee levels appear to be a poor proxy for market power, and there does not appear to be convincing empirical evidence that market power explains changes in interchange fees.

In the absence of such evidence of a compelling problem, the regulatory “fix” of replicating the collusive outcome for merchants and interfere with the normal competitive process appears to be sure to shift rents between sides of the market, but more importantly, to impose a significant risk of doing more harm than good for the consumers it is purportedly designed to protect.

Competitive Payments

Ronald Mann —  9 December 2009

Most of the discussion related to pricing at the point of sale has emphasized the “cross-subsidy” between those that pay with cash and checks and those that pay with credit cards.  This discussion misses the core of the problem in a market where the use of cash and checks is rapidly declining; the central problem is the differential pricing of different card products.  The reaction of the card networks to their “loss” in the debit-card and American Express litigation was to create two new product lines (Visa Signature and World MasterCard) that have unusually high interchange fees, 1-2% higher than typical Visa and MasterCard products.  The rationale for these products from the network’s perspective is two-fold.  First, the increased interchange revenues compensate for lowered interchange revenues on debit-card transactions.  Second, issuers collect higher interchange revenues and thus would not shift their business out of Visa and MasterCard and toward American Express.

The problem from the merchant’s perspective is that these cards differ in no substantial way from the conventional credit products, except that they cost more.  The same customers that formerly used a typical Visa or MasterCard product now use a high-interchange product.  Although those customers often have multiple cards in their wallet from which to choose, they are likely to choose the high-interchange product because it brings them more rewards.  Merchants that do not believe the products motivate increased spending in their stores have no practical response except to refuse all Visa, or all MasterCard products.  Thus, the networks face no price pressure, because the only competitive pressure they face is to keep issuers from moving to other networks.

If the best way to identify prices is to let the market set them, perhaps the best reform is the simplest: allow merchants to discriminate among the products of the various networks, to surcharge or decline products priced at a level that is unattractive to the individual merchant.  Wal-Mart and Walgreen’s might immediately decline to accept Visa Signature and World MasterCard at their current price.  Their customers, predictably, would make identical purchases but simply pull a different card from their wallet.  Macy’s and Bloomingdale’s probably would continue to accept the high-cost products, worried that customers might spend less or go elsewhere if they can’t use their high-rewards cards.  Visa and MasterCard could judge for themselves whether it would be appropriate to decrease, or increase, the interchange fees for those cards.  The outcome, though, would be price levels determined by the attractiveness of the particular products to particular merchants.

The Fee Neutrality Claim

Omri Ben-Shahar —  9 December 2009

Will reduction in interchange fees help or hurt consumers? Two posts yesterday made the conjecture that a reduction in one category of fees would only increase other fees, and that the overall sum of fees will not change. This is the fee-neutrality claim. Todd Zywicki writes:

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.

And Josh Wright agrees:

It would be unwise from a consumer protection policy standpoint to assume that [reduction in interchange fees] 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.

As a logical claim, I tend to agree with this “neutrality” conjecture. Indeed, the Australian experience can be explained in a way that is consistent with this dynamic, as Joshua Gans noted:

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.

The question, though, is what are the implications of fee neutrality. Zywicki and Wright conclude, I believe, that in light of fee neutrality, it is pointless to try to help consumers by capping one component of the overall fee. It will not help, and might introduce an inefficiency.

My claim in this post is that the normative implications are not necessarily as Zywicki and Wright suggest. Fee neutrality, as I understand, applies only to the average cost of using credit cards. That is, consumers who use credit cards end up paying on average the same economic cost, regardless of the division of fees.  But when we consider other measures of consumer welfare, the neutrality claim no longer holds.

First, consumers who use credit cards as payment device and not for borrowing would benefit from the fee substitution. For them, the lower product prices when interchange fees decline are not offset by higher finance charges, because they don’t pay finance charges. So even if the neutrality proposition is correct on average, limits on fees have a distributive effect. This effect could also change the relative uses consumers make. Buying things becomes cheaper, borrowing becomes more expensive, and so we can predict some shift in primary conduct, which, again, violates the neutrality conjecture.

Second, even if for a given consumer the increase in finance and other charges exactly offsets the reduction in interchange fees, it is plausible to expect that a reduction in fees would lead to a reduction in prices of products and change the consumer’s purchasing decisions. Imagine that the interchange fee were to drop, in a hypothetical economy, from 5% to 0.5%. Do we think that product prices will drop accordingly? In response to a comment I posted yesterday, suggesting that such a price decline would occur, Todd Zywicki correctly responds that not all the saving will be rolled over to consumers. It depends on cross-elasticities of demand and supply. But at least in competitive markets, where prices equal marginal cost, the bulk of the savings in interchange fees would be enjoyed by consumers. It may be that nominal prices would display some stickiness, but it’s hard to imagine that in the long run consumers will be deprived of this benefit. One has to have very little faith in markets to imagine that the cost reduction will be enjoyed in its entirety by merchants, through higher profits.

If caps on interchange fees cause a non-trivial effect on prices, this regulation has the potential to reach far beyond the credit card market. It now affects primary decisions regarding the composition of consumption.

It is true that some of the increased demand due to lower prices is offset by the higher cost of credit. To buy these cheaper products with borrowed money would be just as costly, according to the neutrality claim. But it is important to unbundle the overall price into its two pure costs—the cost of the product and the cost of the credit. The potential efficiency of fee limits is in achieving an unbundled price, where the product component and the price component are priced separately.

Geoffrey A. Manne is Executive Director of the International Center for Law & Economics and a Lecturer in Law at Lewis & Clark Law School.

I take to heart Jim’s claim that fraud is too-little discussed in this realm given its cost, and thus I’ll try my hand at it.

Every discussion of the industrial organization of credit card networks owes a debt to Bill Baxter.  Baxter, a law professor and former Assistant Attorney General in the Antitrust Division of the DOJ, was one of the first (maybe the first?) scholars to discuss the economics of two-sided markets, in a paper, as it happens, on the economics of interchange fees in credit card networks.

In simple terms, the essence of Baxter’s analysis is that the role of the interchange fee in credit card networks is to balance and maximize demand for credit card transactions on both the consumer side and the merchant side–optimizing the system by drawing in as many consumers on the one side and merchants on the other as possible while still matching up demand for credit transactions on each side (thus maximizing network benefits).  The lever of the interchange fee allows the system to re-allocate some of the costs that are otherwise born by only one side of the market in order to effect this optimization.  One of these costs is the cost of fraud–and the interchange fee is, it seems to me, an essential lever for re-allocating the costs of fraud within the credit card system to where they can best be born.

Fraud costs are an important, if oft-neglected, component of payment systems’ functioning.  Every payment system by its nature includes the risk of fraud, and every payment system, by design or by default, imposes the risk of fraud on one or more parties in the system.  For example, a merchant that accepts cash in exchange for goods bears the risk that the cash will be counterfeit.  The cost of counterfeit currency to merchants is substantial.  (Although, speaking of cross-subsidies, the cost to merchants likely captures barely a fraction of the full cost of counterfeit currency—a cost born mostly by the government (and passed on to taxpayers) in policing and deterring counterfeiting).  The cash system, essentially by default, imposes the residual fraud costs on the merchant.  Checks present an even greater fraud problem than cash and, again, the costs are allocated essentially by default: A merchant that accepts a fraudulent check will bear the cost of the fraud.

In principle, the fraud costs of checks or cash could be allocated differently.  The government could offer some sort of guarantee, or the issuing bank could agree to bear the cost.  But in part because the government requires banks to clear checks at par—has, in other words, fixed the interchange fee at zero for checks—there is little opportunity for the system’s lever to operate to reallocate these costs, ensuring that the costs lie where they fall, and that redistribution is made only in the parts of the system governed by explicit contracts (thus, for example, depending on a host of factors, some of this cost may be redistributed from merchants to merchants’ banks via reductions in various fees in the agreement between merchant and bank).

In contrast, the flexible interchange fee in the credit card system allows fraud costs to be allocated differently throughout the system, presumably ensuring not that the costs lie where they fall, but rather that they are born by the party best positioned to bear the costs.  In the case of credit cards, assuming the merchant complies with the network’s rules for seeking authorization of payment, the issuing bank, in fact, guarantees the payment (and thus bears the risk of non-payment).  As Bill Baxter noted, “[t]his shifting of risk under the [credit card] system obviously increases [the issuing] bank’s cost, enhances [the merchant’s] demand for the system, and increases the amount of discount [the merchant] is willing to pay to [the acquiring] bank.”  It is this re-allocation of costs, facilitated by the interchange fee, that helps to optimize the system.

The GAO has a fairly extensive discussion of the costs and benefits of credit cards to merchants.  However, that discussion focuses on the individual benefits.  I would like to step back and put two of those benefits – increased merchant sales and fraud prevention costs – into the larger context that I discussed earlier.

First, there is the question of credit cards increasing merchant sales.  How exactly does this occur?  One possibility is that if some merchants accept credit cards and others do not, then some people will switch their business to the merchants that take credit cards.  From the point of view of the merchants taking credit cards, their sales most certainly go up.  From the point of view of the merchants which do not take credit cards, their sales go down.  From society’s point of view, sales are moving from one business to another, but total sales do not change.

Another possibility is that credit cards provide ready access to a line of credit, allowing people to make purchases on credit that they otherwise would not be able to make.  If so, it is not clear how much of an effect on sales that would really have.  Credit cards are not the only source of credit in the economy.  Also, credit has to be paid back.  In the short run, credit can certainly increase sales, but, as the economy is so painfully reminding us right now, in the long run the bills have to be paid, so it is not clear that total sales over time increase.

It is also possible that credit cards are just more efficient than other payment methods and save both consumers and merchants money.  If that is the case, then there is more money to spend in the economy and sales can go up.  Research suggests, however, that the differences between different payment methods (in terms of the real resources used to process a payment) are relatively modest, often less than one cent per dollar spent.

Overall, then, it seems likely that most of any sales increase will come from moving sales between merchants.  Intuitively, this makes sense.  If you were told that you could not use any credit cards for the next five years, would your total spending over those five years be substantially lower?  On the other hand, if you were told that a store down the street was not going to take credit cards anymore, would your spending at that store fall?  Increased sales for a merchant may be good for that merchant, but whether society is better off is a different question.

Fraud is a different matter, though.  Fraud takes money from some people and gives it to others.  However, we as a society disapprove of fraud and do not wish to reward criminals.  Thus, we view fraud losses as purely a bad thing for society.  Unfortunately, all payment methods are subject to fraud.  The GAO discusses costs of prevention for credit cards, but does not discuss the direct costs of fraud to merchants and consumers.  Criminals go where the money is, and a lot of money flows through credit card receipts.  Restaurant tips get changed, card numbers get stolen, transactions get rerun for higher amounts, cards are cloned – there is an endlessly changing list of fraudulent activities.  Many of these activities are difficult to detect.  For example, when the tip on a receipt is changed, many people will never notice, even though they just had money taken directly out of their pocket.  Estimates on the costs of fraud for different payment methods vary, but there is general agreement that all payment methods are subject to fraud and that debit cards (when authorized with a personal identification number) have some of the lowest overall fraud rates.  Different people bear the costs of fraud depending on the type of fraud and the payment method.  Merchant costs for losses and prevention are important, but they are not the only ones affected.

James Van Dyke is President and Founder of Javelin Strategy and Research.

I feel that at least two important issues are being left out of the raging controversy over the cost of interchange. (At this point my readers are probably deciding if I’ll follow with a pro-merchant or pro-bank POV…but guess what: here comes one of each to make my point that we’re being a bit simplistic in this debate!).

Point one: card fees replace other costly forms of payments, and this must be included in any policy discussion. Previous Javelin research of several hundred merchants found that total costs for handling checks and cash are often considered to be as high as those for cards. Cash comes with risk of employee fraud, and may prevent consumer sales for those without current access to paper or cash money. Every check is an incident of fraud waiting to happen, as these antiquated IOU instuments are essentially dead or dying in every country other than the U.S. Checks invite criminals to follow the simple methods documented by Frank Abagnale of “Catch Me If You Can” fame.

Point two: Any discussion over cost of interchange should include a review of who pays for fraud. Between merchants and banks, if there is a disparity over who handles the brunt of fraud (the recent study we did for LexisNexis found that merchants incur 90% of direct fraud cost) brings up issues of incentives. Simply put, if you can pass a cost on to someone else your incentive for minimizing the cost may be reduced.

And now that I’ve said something to anger both merchants and bankers, I’ll eagerly await the responses…