Archives For interchange and credit cards symposium

In my first post I argued that consumers as a group would likely be made worse off as a result of artificially imposed reductions in interchange fees.  This post considers a second line of attack—that even if consumers overall would be made no better off (or even worse off) as a result of regulating interchange fees, Congress should intervene in the name of “fairness” to regulate interchange fees.  This “fairness” argument, however, is a red herring, especially when advanced by merchants purporting to speak for consumers.  Indeed, the sincerity of the merchants’ concern is belied by their own behavior.

Merchants claim the current interchange price (typically about 1.75% of the price of the transaction) is “unfair” to those customers who pay by cash or check (and thus don’t incur interchange fees) because cash customers are essentially forced to subsidize credit users who pay the same retail price but incur this additional cost.  Note first that whether a reduction in interchange fees would be passed through to consumers is a question of market dynamics.  There is no evidence that Australia’s cap on interchange fees resulted in lower retail prices for consumers.  Even if retail prices did fall there is no evidence that any retail price reductions offset higher credit prices to consumers or would benefit consumers equally.  While capping interchange fees might eliminate the purported unfairness by making credit purchasers worse off, it is questionable whether it would actually make cash customers better off.

But merchant critics of credit cards on “fairness” grounds are playing with a stacked deck: cash and checks are both subsidized payment mechanisms.  The government prints and replaces worn currency and the Federal Reserve clears checks at par. By contrast, credit card issuers bear the cost of maintaining their payment network.  If merchants were serious about accurately allocating the costs of the payment network then they would insist that the government eliminate these subsidies from the system.  And this doesn’t even count the deadweight costs to the economy of cash, such as the time consumers spend making ATM transactions or the cost of paying guards to drive around pieces of paper in armored cars.  Studies find that consumers who write checks take twice as long at the check-out line as those who use payment cards—forcibly imposing an external cost on everyone in line behind the check-writer.  Should check-writers be required to compensate the rest of us for our wasted time standing in line?

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.

Moreover, federal law expressly permits merchants to give cash discounts (some do).  That most merchants choose to accept credit cards and charge one price for cash and credit reflects a simple business decision, just like offering free parking (thereby subsidizing those who drive versus those who walk or take the bus), manned check-out lines (subsidized by those who use self-check out), or free returns on merchandise or money-back guarantees (subsidized by those who don’t return products).  Starbucks customers who drink their coffee black subsidize those who use cream and sugar.  Movie-goers who attend primetime shows subsidize those who attend matinees. Consumers who pay full price subsidize those who buy the same product on sale a few days later.  In a free economy we allow the scope of these cross-consumer “subsidies” to be set by free contracts, not governmental mandates.

The insincerity of the merchants’ fairness concerns is illustrated by their own behavior.  Traditionally, many retailers operated their own in-house credit operations.  This included large department stores, but also many grocers, tailors, furniture, appliance, and hardware stores that offered credit to customers on open-book or installment credit.  Many an older lawyer has related to me the memorable experience of opening his first charge account at Brooks Brothers (or the local equivalent) when buying his first suit.  Maintaining these credit operations were quite expensive—the retailer had to bear the operational costs (employees, billing operations, underwriting, customer service), the risks of non-payment and fraud, and the time-cost of money of the delay in receiving payments from the billing cycle and grace period.  Despite this high cost, however, many merchants made a business decision to maintain credit operations because of consumer demand.

Today, many merchants (especially smaller one) have essentially outsourced their credit operations by terminating their in-house programs and accepting credit cards instead, a much less costly system.  Credit cards eliminate the operational cost and non-payment risk associated with maintaining an in-house credit operation.  Credit card issuers bear the cost of the delay in payment over the billing cycle and grace period.  Outsourcing credit also allows small businesses to compete on equal footing with larger businesses that could afford the cost and risk of in-house credit operations.  Some major retailers, however, continue to run their own proprietary credit operations, accepting the higher cost and risk in exchange for the benefits of retaining in-house control.

Why is this history significant?  Because during these decades when merchants operated their own credit operations (and where they continue to do so) they consistently charged the same retail prices for cash and credit consumers despite the higher costs of credit customers than cash customers.  Target’s proprietary credit operation, for example, has been battered by double-digit default rates on its credit portfolio—yet Target charges the same price for cash and credit consumers.  Some merchants even offer “twelve months same as cash” and other promotions that subsidize credit purchasers.  In a similar vein, empirical studies have found that during the 1970s when state usury laws limited the ability of lenders to charge market rates of interest on consumer credit, retailers responded by increasing the price of goods typically sold on credit (such as appliances), thereby burying the price of the credit in a higher price of the goods for all purchasers.

Thus, the merchants’ claim today that the interchange fee forces an unfair subsidy between cash and credit purchasers is a red herring: merchants were (and are) more than happy to force charge the same price for cash and credit—so long as the merchants were capturing all the benefits.  The difference today has nothing to do with fairness, but that the merchants don’t get to keep all the profits.  And that they want the benefits of credit cards (making the issuers bear the cost and risk) without the costs.  Indeed, given that the merchants have outsourced their credit operations to credit cards precisely because they are less expensive, the size of this subsidy is probably smaller today than it was when merchants ran their own operations.  And even this ignores the various costs associated with accepting and handling cash and checks that credit users implicitly pay as subsidies for those types of payment.

Merchants have made a business decision to accept credit cards because it is cheaper and less-risky than running their own in-house credit operations.  As such, the cost of accepting credit cards is a cost of business, just like rent, utilities, and employee salaries.  Let’s get the real issue clear then—the argument over interchange has nothing to do with fairness or benefits to consumers.  Merchants are speaking for themselves, not consumers, when they demand to pay lower interchange fees.  The merchants own behavior demonstrates the point.  Congress needs to stay out of this issue.

(NB:  We have consulted with Visa U.S.A. Inc. on a variety of issues; the views expressed herein are our own.)

In our earlier post, we observed that the GAO report on interchange got off on the wrong foot when it concluded that interchange fees were rising.  We infer from the silence which greeted our post that everyone agrees with this criticism.  Indeed, yesterday’s posts and comments appear to agree that the GAO’s report does very little to advance the discussion of interchange or the cost of electronic payment.  But we suspect that greater disagreement lies just around the corner.

A number of posts yesterday promised to address the claim on which the criticism of modern payment systems rests–the extent to which the discount that merchants pay to accept most electronic payment systems in the U.S. imposes a tax on legacy payment instruments such as cash and check  Mark Seecof seized upon this point in his comment on Ron Mann’s post.  According to Mark, the “big problem” with the payment card industry is that discount fees are used to fund rewards programs, and he claims that society as a whole would be better off if the government simply forbid networks from enforcing their honor all cards rules and force networks to negotiate acceptance on a program-by-program, issuer-by-issuer basis.  The claim that increasing transaction costs will produce more efficient outcomes is a curious one.  But we’ll save that issue for a later day.  Rather, with this post we intend to take up the predicate of Mark’s post–that discount fees on electronic payments shift costs to users of legacy payment instruments.

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.

Second, from a social policy perspective, whether interchange forces legacy buyers to pay more should raise a concern only if legacy is more efficient.  But it’s not.  It is hard to believe, as some people suggest, that credit cards and other electronic payments are more expensive than cash and checks.  In fact, legacy payments have several limitations that create costs for both consumers and merchants.  Cash only works well when the good and payment are exchanged simultaneously.  And the technology of cash does not support the instantaneous decision to give credit to the person buying; rather, the buyer has to arrange credit separately with a financial institution.  In addition, with cash, you have no recourse against fraud, other than bringing suit.  (On the costs of cash, see Daniel D. Garcia Swartz, Robert W. Hahn, and Anne Layne-Farrar, The Move Toward a Cashless Society: A Closer Look at Payment Instrument Economics, Vol. 5, Issue 2, Review of Network Economics 175, 192 (June 2006) (describing cash as “among the most costly payment method[s] for society”)).  Similar transaction costs and risks accompany the use of checks.

By contrast, there are numerous benefits to using credit cards and other electronic payments.  For consumers, these benefits include the extension of credit real-time, the reduction of risk, automated dispute resolution, and better record keeping, as Garcia-Schwartz, Hahn and Layne-Farrar demonstrate.  For merchants, accepting credit cards allows them to make sales on credit at a generally lower cost than operating their own credit program.  And merchants can receive faster and more certain payment from customers using cards than from customers using other means, such as checks.

Third, and most significantly, the rapid growth of online payments within the retail industry is rendering legacy payments obsolete.  The GAO itself seems generally aware of the shift from legacy to electronic payments.  Indeed, it cites the Federal Reserve’s recent estimate that the use of both checks and cash have declined, or at least grown more slowly than credit and debit card use, since the mid-1990s as more consumers switched to electronic forms of payment.  Since 2005, more than half of total retail transactions have used either credit or debit cards.  Large national merchants report that sales made with cash and checks have decreased in recent years, while sales made with credit and debit cards have increased.

But the GAO ignores that the argument in favor of regulating interchange to protect cash and check users, whatever its overall merits, is logically limited to areas where legacy forms of payment can be used.  And those areas are quickly vanishing.  For example, even if a study of the 1980s retail gasoline market were to suggest the existence of cross-subsidies then—a debatable conclusion—that study cannot be read to suggest the existence of such a subsidy among people who shop on-line or who buy their gas at automated fuel dispensers.  According to scholars, we are rapidly moving towards a cashless society where no one uses legacy instruments such as cash or check.  And there is simply no reason to believe that this move is driven by the inherent inefficiency of electronic payment or an implicit tax on users of cash or check.

The GAO’s misplaced concern for users of legacy payments is yet another example of a theoretical objection to unregulated interchange that finds no support in the facts.  According to Garcia-Schwartz, Hahn and Layne-Farrar, “the shift toward a cashless society appears to improve economic welfare,” with consumers the party most likely to benefit.  But, if history repeats itself, we will likely have to continue to endure the interchange debate regardless of the facts.  As the GAO’s report again reminds us, merchants simply want to pay less for the benefits that credit cards provide.  Not surprisingly, they are in this debate for themselves, not their consumers.

Welcome to Day Two

Geoffrey Manne —  9 December 2009

The Law and Economics of Interchange Fees and Credit Card Markets

Welcome to day two of of our two-day symposium on the law and economics of interchange fees and credit cards.

Our symposium brings together several of the world’s leading experts on interchange fees and the law and economics of credit card markets.  Our participants will discuss a range of issues surrounding the regulation of interchange and credit card markets.

Today’s posts will cover the following topics:

  • Assessing Cross-Subsidies.  Posts from Tom Brown & Tim Muris and Todd Zywicki
  • Assessing the Network Rules.  Posts from Bob Chakravorti and Joshua Gans
  • Considering the Costs: Fraud.  Posts from Jim Van Dyke, Allan Shampine and Geoffrey Manne
  • Additional Responses and Closing Thoughts.  Posts from Omri Ben-Shahar and Joshua Wright and TBD

The posts will appear regularly throughout the day to allow time between posts for discussion: Check back for updates and comments.  Expect free-ranging discussion in the comments–most of these issues are inter-related and we will return to several themes throughout the symposium.

You can find all of the symposium posts under the “credit card symposium” link on the right side of the page.

Thank you for joining us!

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There is nothing like the provocative post from Allan Shampine to move this debate up a notch.  First, I did not say that the debate over interchange fees was Onionesque. I reserved that dubious distinction to the on-the-hand-on-the-other-hand title of the GAO report.  Allan is right that the stakes are huge, which is why this debate is so important.  But he is wrong to think that the GAO adds much to the debate when all it can responsibly say is that any regulation of interchange fees has both costs and benefits, when it is unable to quantify or evaluate either.

My own substantive view starts with the legal version of the Hippocratic Oath—first, do no harm.  That generally counsels against the interference with competitive markets.  But it does not, evidently, have quite the same pop in the complex world of interchange agreements where there are sure to be some pockets of monopoly power.  But even if that were the case, the second order concern remains true.  Is the cure proposed likely to be worse than the disease, which I suspect will be the case if there is no clear path from diagnosis to treatment.

On this issue, the excellent posts by Tom Brown & Tim Muris, Robert Stillman, and Todd Zywicki all make the same point.  As Zywicki properly notes, the credit-card system is a closed loop.  The loss of revenues from one part of it has to be offset by the gains in revenues elsewhere.  It becomes therefore very difficult to construct a telling narrative that justifies the use of high administrative costs to switch these flows in a direction that retailers prefer, but which do little good for others.  As Brown & Muris point out, fully corrected for debit cards, there is no run up in interchange costs, so why worry.  As Bob Stillman points out, if the merchants were prepared to make a dollar-for-dollar pass through of fee reductions, they would have no incentive to lobby so hard for a program from which they received no return.  I think that they have better knowledge of their own business than I do, so that the question of who pays if they get a government break still remains.

Allan is surely right to point out that the 1.7 percent interconnection fee is not chump change.  It is larger than the 0.5 percent reduction in sales taxes that is being mooted in Chicago.  A fair comparison would ask about the change in effective rates that regulation could impose.  But even if we put that aside, the structural differences between interchange fees and the sales tax really matters.  The sales tax takes wealth out of the productive cycle of credit (indeed all) sales.  The one unambiguous effect is that Chicago purchasers now have an incentive to shop in the suburbs for their large weekly household purchases, and even for smaller transactions like gasoline.  Governing a long and thin city has important tax consequences because it puts a lot of people close to city lines, and also to Indiana.  Cutting down the fees brings business back.

There of course no taxes involved in this dispute, just lots of dollars.  But the flip side of the tax issue does arise with subsidies for various payment systems.  Here one of the great achievements of credit cards is that it does not have the public subsidy that is found both for checks, and for cash, when, last I looked, no one had to pay a cent to acquire a shiny new $20 bill.  The government assumes the printing costs, and guards against counterfeit transactions, a rough analogy to credit fraud.  If this industry can continue to expand its share of the market, hands off looks to be the better solution, if only because there are more players who can divide the substantial fixed costs in running this system.

Conclusion: even if you cancel your Onion subscription, don’t buy into the regulation of interchange fees until the GAO can supply a better narrative than it has already done.

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.

Omri Ben-Shahar is the Frank and Bernice J. Greenberg Professor of Law at the University of Chicago.

I will focus my blog post on one of the proposals for reducing interchange fees: the requirement that the fees be disclosed to consumers. I am not sure how seriously this option is taken by the GAO report. Indeed, the report concedes that mandated disclosures in this context are not very likely to be effective, because “consumers are likely to disregard this kind of information.” But I will not be surprised if, of all the regulatory options discussed in the report, in the end it will be the disclosure rule that is enacted.

I am sure that readers of this blog don’t need a long explanation why disclosures would be futile in this area. Numerous studies have documented the failure of mandated disclosures in other areas of consumer credit, ranging from TILA, through other financial accounts such as depository, savings, and mutual funds, and extending to disclosure by financial brokers, investment advisers, credit reporting agencies, and even pawnshops. These mandated disclosure rules fail to inform people, to improve their decisions, or to change the behavior of the financial institutions. The fail because ordinary people can read them, can’t understand them even in the most simple format, don’t know what to do with the information even it were understood, and face way too many such disclosures in their every day lives

I recently conducted a study looking at the entire body of mandated disclosure statutes that people encounter, reaching beyond financial transactions.  (You can view a talk based on the study here). Mandated disclosures are a routine regulatory device found in insurance law, health care, informed consent doctrine, Miranda warnings, IRBs, and hundreds of product- and service-specific enactments. My study concluded that none of these disclosures do anything to help people, and many of them backfire. One of the features that runs through all these scattered disclosure statutes is how easy it is politically to enact them. When lawmakers respond to a particular problem that requires intervention—much like the one we are now discussing, interchange fees—there is often debate what rules would work, how deep the intervention ought to be, and whose interests to prioritize. But there is very little debate or opposition to disclosure mandates. Everybody supports them. The perception is that more information is always better: it helps people improve their decisions, it “bolsters their autonomy” as some like to put it, and it perfects market competition. At worse, disclosure believers think, the information will not help much, but it surely will not do any harm, and disclosure regulation involves very little budgetary allocation.

Here is a case in point. Just last month, the Federal Reserve regulated overdraft fees.  After much thought and consultation, the Fed found a solution to the problem of high overdraft fees for ATM and debit card transactions. Recognizing that many consumers would prefer that money withdrawal would be declined rather than pay a sizeable overdraft fee, the rule enacted by the FED prohibits banks from charging overdraft fees unless consumers opt in to the overdraft fee option. Sounds sensible: give people choice, and set the default rule to induce information dissemination.

But here is the catch. How, according to the legislation, would consumers learn about the size of the overdraft fees and choose, if they care, to opt in? By establishing mandated disclosure requirements! That is, to make sure that the notice is “meaningful”, the Fed, with the support of consumer advocates, mandated a new form—which they call a “segregated disclosure”—a separate sheet consumers will receive from the bank providing them “a meaningful way to consent and thus to providing meaningful choice.” The ingenious advance here, which ensures “informed choice,” is to have a separate form, with a separate notice, and a separate signature. This, supposedly, will prevent “inadvertent” consent.

Like any other technical financial disclosure, this format is unlikely to help, especially the least sophisticated consumers—those most likely to carry overdrafts. Whether it is one form of separate forms, one notice or separate notices, one signature or separate signatures, this will not change the ineffectiveness of this disclosure paradigm. Consumers will get yet another pre-printed boilerplate page, with another dotted line at the bottom, which they will happily not read.

The point is that, when all is said and done, nothing much happened. There was a moment of significant public and media attention to the problem of overdraft fees, but in the end they were not regulated. Another meaningless disclosure was added to people’s lives, already swamped with hundreds and thousands of disclosures. Politically, the Fed finished its job and the problem is now “solved.” This is a familiar pattern: a disclosure rule provides an excuse to refrain from a real solution.

Now back to interchange fees. The GAO report lists several possible policy options, from direct regulation of the fees to restrictions on the terms imposed by issuers and how they are negotiated. These are controversial options that would likely lead to substantial political wrestling. There is also much uncertainty, even among the most sophisticated of academic experts, as to the effects of these measures. Perhaps other entries to this blog will shed more clarity as to the right regulatory direction. But as long as these difficulties remain, and as long as interest groups exert pressure on lawmakers, disclosure rules will once again surface as a safe, unopposed, but unfortunately useless regulatory device.

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.

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.

Sujit ‘Bob’ Chakravorti is a senior economist in the financial markets group at the Federal Reserve Bank of Chicago.

Disclaimer: These views are my own and not those of the Federal Reserve Bank of Chicago or the Federal Reserve System.  Much of this discussion is taken from my paper titled “Externalities in Payment Card Networks: Theory and Evidence” presented at the Federal Reserve Bank of Kansas City’s 2009 Retail Payments Conference.

The proliferation of payment cards has dramatically changed the ways we shop and merchants sell goods and services. Today, payment cards are indispensable. Recent payment surveys also indicate that consumers are using payment cards instead of cash and checks. Some merchants have started to accept only card payments for safety and convenience reasons. For example, American Airlines began accepting only payment cards for in-flight purchases on all its domestic routes since June 1, 2009. Wider acceptance and usage of payment cards suggest that a growing number of consumers and merchants prefer payment cards to cash and checks.

To date, there is little consensus on what constitutes an efficient fee structure for card-based payments. Reviewing the economic literature on payment cards, I find that no one model is able to capture all the essential elements of the market for payment services. It is a complex market with many participants engaging in a series of interrelated bilateral transactions. Much of the debate over various payment card fees is concerned with the allocation of surpluses from consumers, merchants, and banks, as well as the question of who is able to extract surpluses from whom. Economic models of payment cards generally ignore the allocation of surplus among participants at a given level of social welfare but instead focus on externalities that prevent achieving the highest social welfare.

There are several conclusions that I draw from the academic models. First, a side payment between the issuer and the acquirer may be required to get both sides on board.  In this case, the side payment is the interchange fee. This side payment may skew the prices paid by end-users.  This sort of asymmetric pricing exists in other industries such as newspapers (readers and advertisers), dating clubs (price differences for men and women), and software such as Adobe Acrobat (document readers and creators). Once fully adoption is reached or the market has reached saturation, the adoption externality disappears but the usage externality may remain.

Second, many economic models suggest that the socially optimal interchange fee structure may not be systematically lower than the network profit-maximizing fee. In other words, the lowest fee is not the one that maximizes social welfare. Wilko Bolt and I construct a model where underlying cost structures such as credit card defaults, crime, and system operating costs determine the optimal acceptance of payment cards. For certain sets of cost parameters, we find that the socially optimal merchant fee may be higher than the bank profit-maximizing merchant fee.

Third, removing merchant pricing restrictions generally improve market price signals. While consumers generally react to price incentives at the point of sale, merchants may be reluctant to charge higher prices to consumers using certain types of payment cards. However, surcharging is increasing in jurisdictions where it is allowed. Furthermore, the ability to surcharge may increase the bargaining power of merchants resulting in downward pressure on merchant and interchange fees.

Fourth, merchant, card issuer, or network competition may result in lower social welfare contrary to generally accepted economic principles. Merchants may use card acceptance as a tool to steal customers resulting in the willingness to pay higher fees. But, when all merchants accept payment cards, total sales across merchants remains constant. Card issuers may try steal cardholders from their competitors with incentives partially or wholly paid for by interchange fee revenue. The recent GAO report suggests that interchange fee revenue may be necessary for some smaller community banks and credit unions to issue credit cards so that they can be competitive with larger issuers especially if fewer of their cardholders revolve debt. Lastly, network competition may put upward pressure on interchange fees because networks are competing for issuers that prefer higher interchange fee revenue given all else equal.

Fifth, both consumers and merchants value credit extended by credit card issuers (along with other benefits such as security), and consumers and merchants are willing to pay for it. When credit cards were first introduced, many smaller merchants adopted general-purpose cards to reduce costs associated with direct lending to their consumers. Merchants often offer subsidized credit to their customers to gain loyalty or increase sales.

Sixth, if warranted, fees set by the authorities should not only consider costs but also benefits received by consumers and merchants, such as convenience, security, and access to credit that may result in greater sales. Policymakers in various jurisdictions often regulate interchange fees by only focusing on costs. Both consumers and merchants may benefit from cards and it is not clear that one party should not pay for it. Clearly, regulating interchange fees by costs and benefits would be difficult.

In reality, the motivation for why public authorities intervene differs across jurisdictions. In addition, the type of public institution that regulates payment cards also differs. The institution may be an antitrust authority, a central bank, or a court of law. Often public authorities intervene because the interchange fee is set by a group of competitors and the level of the fee is deemed to be excessive. In other cases, by mandating fee ceilings, authorities expect greater number of merchants to adopt payment cards instead of cash. In addition to cash handling and safekeeping costs, some public authorities may find the inability to trace cash transactions an unattractive feature of cash.  Alternatively, some policymakers argue that lowering card issuers’ interchange revenue may reduce incentives to cardholders to use more costly payment cards (for example, credit cards instead of debit cards).

Determining sound public policy regarding the allocation of payment fees is difficult. The central question is whether the specific circumstances of payment markets are such that intervention by public authorities can be expected to improve economic welfare. Efficiency of payment systems is measured not only by the costs of resources used, but also by the social benefits generated by them. Clearly, further research is warranted to explore the complex market for payment services, and policy recommendations should be based on more in-depth research, especially empirical studies that focus on the effects of government intervention.

Thomas Brown is a partner in O’Melveny and Myers’ San Francisco office.  Timothy J. Muris is Foundation Professor of Law at George Mason University School of Law and Of Counsel in O’Melveny & Myers’ Washington DC office.

Next summer, the World Cup, the world’s most watched sporting event, marks its quadrennial return.  Although thirty-two teams will compete in South Africa, the list of favorites begins with the two teams that have won half of the previous eighteen tournaments and three of the last four—Brazil and Italy.  Brazil plays an open and flowing brand of soccer.  Italy sits back and pounces when its opponents stumble.  Although Brazil and Italy follow different philosophies, they have achieved similar success because both have adopted strategies to overcome the adversity that inevitably arises in a major tournament.  Even a weak opponent can manage to score a single goal when a referee blows a call.  But good teams find a way to overcome.

Long-running legal and policy debates have the feel of the World Cup.  Firms on either side of an issue develop their arguments for and against particular policies, and they stage matches between their respective positions in journals and before Congress, courts and administrative agencies.  Legislators, judges and administrators observe those skirmishes and, ultimately, render decisions.  One hopes that these decisions reflect the relative merits of the parties’ competing positions.  But even well-intentioned officials make mistakes.  The challenge for a firm engaged in a long-running debate is to develop persuasive arguments even in the face of mistakes by the decision makers.

We found ourselves thinking about the ability of generations of Brazilian and Italian soccer players to overcome adversity as we read the GAO’s much anticipated report on interchange.  Although we agree with the report’s ultimate conclusion, we were surprised at how the GAO reached this result.  The GAO accepted as true the point from which critics in the U.S. launched their attack on interchange—that “rising interchange fees have increased costs for merchants.”  The GAO nevertheless recognized, correctly in our view, that the government should neither set rates nor prevent the networks from enforcing the many acceptance rules about which merchants complain.  And the fact that the GAO reached this conclusion notwithstanding its flawed analysis of the changes in interchange rates over the recent past is yet more evidence that the networks have the better of the argument.

Interchange is a function of network architecture, not product design.  When a payment network supports multiple issuers and acquirers (i.e., allows multiple financial institutions to issue payment products to consumers and to sign merchants to accept those cards), it needs some mechanism that enables those issuers and acquirers to exchange their transactions.  This design explains why Discover, but not American Express, has adopted an interchange mechanism.  Discover has opened its network to third-party issuers and acquirers.  And like Visa and MasterCard, it sets the rate at which issuers and acquirers on its network exchange transactions.  American Express now supports third-party issuers, but it remains the sole acquirer on its network.  It compensates issuers for providing transactions, but it does not need an interchange device.

Interchange fees are as much a feature of the transactions that consumers initiate with pre-paid and debit transactions on the Visa, MasterCard and Discover networks as the fees are on the networks’ credit transactions.  But the GAO limited its analysis of the change in interchange rates over time to credit transactions, rendering useless this aspect of GAO’s analysis.  The centerpiece of the analysis of the change in rates over time is found in Table 2 at page 15.  There, the GAO reports that 43% of Visa rates and 45% of MasterCard rates increased between 1991 and 2009.

But the GAO neglects to mention a significant intervening event—the resolution of the Wal-Mart litigation.  That settlement allowed merchants to accept Visa and MasterCard credit cards without also accepting the network debit cards.  (See In re Visa Check/Mastermoney Antitrust Litig., 297 F. Supp. 2d 503 (E.D.N.Y. 2003), aff’d, Wal-Mart Stores, Inc. v. Visa U.S.A. Inc., 396 F.3d 96 (2d Cir. 2005)).  And the settlement must be considered when comparing the post-settlement rates to the pre-settlement rates.  Prior to the settlement, credit and debit transactions were offered in a bundle.  Post-settlement, the transactions were offered independently.  Although the system-wide average rate did not change following the settlement, the prices of the components moved in different directions.  Credit rates increased, while debit rates fell.  (See Chart 3 here).

The report offers no explanation for the GAO’s decision to limit its analysis of changing interchange rates to credit transactions or omit discussion of the Wal-Mart litigation.  Although the legislation commissioning the report sought an analysis of the effect of interchange on credit cards, the report as a whole discusses interchange more generally.  And Visa and MasterCard tried to persuade the GAO to examine changes in all fees.  The report acknowledges that both Visa and MasterCard told the GAO that “their average effective interchange rates applied to transactions have remained fairly constant in recent years when transactions on debit cards, which have lower interchange fee rates, are included.”  The GAO’s response to this observation is a non sequitur:  “[h]owever, our own analysis of Visa and MasterCard interchange rate schedules shows that the interchange rates for credit cards have been increasing and their structures have become more complex.”

Moreover, interchange fees relate to but are different from the prices that merchants pay to accept payments.  Changes in rates often but do not always affect the prices that merchants pay to accept particular forms of payment.  (See chart 4 here).  Whether a given rate applies to a given merchant turns on the nature of the rate (i.e., whether it applies to all merchants or just some), the investments that the merchant has made in its acceptance technology, and the merchant’s skill in negotiating with its acquirer.  And the net effect of increases in some rates and decreases in others depends on the mix of transactions at that merchant.  The weighted average interchange rate may have declined over time for merchants with proportionally more debit transactions than credit transactions.  The first clause of the title of the GAO report should thus read “Changing Interchange Rates Have Had Varying Effects on the Prices That Different Merchants Pay to Accept Different Types of Payments.”  (The first clause of the title of the GAO Nov. 2009 Report actually reads:  “Rising Interchange Fees Have Increased Costs for Merchants.”)

But the larger point for purposes of this comment is that the alleged increase of interchange rates and its effect on merchant costs merely opens the inquiry.  Many questions follow.  Higher interchange rates may drive additional sales for merchants, enable electronic payments to displace less efficient (or more expensive) legacy forms of payment, or reduce the costs of electronic payment for consumers.  The GAO report documents the existence of each of these benefits.  And it confirms that efforts to regulate interchange rates or reform acceptance rules have shifted costs from merchants to consumers.  For these reasons, the GAO’s report, on balance, provides little comfort to interchange critics.

Allan L. Shampine is a Vice President at Compass Lexecon in Chicago

While the GAO report provides a useful summary of many of the issues being debated within the credit card community, the GAO’s mandate was, in some ways, rather narrow.  The GAO was asked to “review (1) how the fees merchants pay have changed over time and the factors affecting the competitiveness of the credit card market, (2) how credit card competition has affected consumers, (3) the benefits and costs to merchants of accepting cards and their ability to negotiate those costs, and (4) the potential impact of various options intended to lower merchant costs.”  We will be talking a lot about their conclusions on these issues, but first I would like to set the stage by talking about where credit cards fit in the economy as a whole.

Credit cards are a way of buying things, but they are only one of many.  Other common methods include cash, checks and debit cards.  Each payment method touches different groups, directly and indirectly.  Academics, central banks and regulators around the world have debated for many years as to which payment methods are best for society as a whole.  The research into this question suggests that there is no simple answer.  Indeed, researchers have not even agreed on how to ask the question.  Some researchers say that trying to figure out all the costs and benefits is just too hard and we should concentrate on the overall costs of the system.  In particular, electronic payment methods are often regarded as less costly than paper payment methods.  Other researchers (including myself) point out that consumers stubbornly continue using paper payment methods even as they become more expensive (relative to other payment methods), showing that there must be benefits to doing so, and that those benefits are important enough to influence people’s choices.  Most researchers agree, though, that different payment methods are better in different circumstances.  For example, for a small transaction at a garage sale, cash is very efficient.  You don’t need any terminals, electricity or approvals.  You hand over the cash and you’re done.  If you’re buying a house, though, cash is not a good choice.  You’re almost certainly going to use a wire transfer.  If you’re at Starbucks getting a cup of coffee, you might use cash or credit, although the cashier and the other people in line are likely to grind their teeth if you choose credit.

That examples brings up another problem that regulators wrestle with.  When you pull out your wallet to pay for something, you ask yourself questions like “Do I have enough cash?  Should I use my credit card for the rewards?  Should I use my debit card to stick to my budget?”  You do not ask yourself, “How much will this cost the merchant?  How much will this cost the bank?  Are other people going to pay a higher or lower price because of this?  Am I going to slow down the line?”  (Well, most people don’t.  If you’re reading this blog, you may be the exception that proves the rule).  That is, you choose how to pay for things, but the “price” you face for using whatever payment method you choose may not reflect all of the costs and benefits to everyone else.

This distinction is important because whether something is good for an individual does not necessarily mean that it is good for society.  If networks take money from some merchants and give it to people using credit cards, at first blush, those merchants are worse off while credit card users are better off.  But what does that mean for society?  Do prices go up?  How does that affect consumers?  How does that affect merchants?  How are the owners of the networks affected?  These are not simple questions.  Hopefully this overview will provide something of a framework to discuss them in.

Robert Stillman is a Vice President in the European Competition Practice of Charles River Associates

Interchange fees on payment cards are obviously a hot topic in the United States, but also in Europe and in many other countries around the world.  The report on interchange fees released last month by the US Government Accounting Office (GAO) notes that more than 30 countries have intervened or are considering intervening in the payment card industry.

Australia is one of the countries where there has been significant government intervention.  Most notably, the Reserve Bank of Australia (RBA) implemented a regulation in October 2003 that had the effect of reducing the average interchange fee on credit card transactions by approximately 50%.

From research that I have done on the effects of the regulations in Australia and from my reading of the ever-expanding literature on the economics of payment cards, I think there are a number of propositions about payment cards that are well supported by economic theory and the available evidence and that should constrain any debate about payment card issues.  I will be interested in the extent to which other participants in this blog symposium agree or disagree:

1.  A reduction in interchange fees will lead to reductions in merchant discount fees.

This proposition is almost trivial.  If this were not the case, it would be difficult to understand why merchants complain so vociferously about interchange fees.

2.  If interchange fees are reduced, it is highly unlikely that the resulting decline in merchant discount fees would be quickly and fully passed on to consumers in the form of lower prices and/or higher service levels.

The fact that merchants lobby vigorously for reductions (or even the elimination) of interchange fees must imply that merchants expect their profits to increase if interchange fees are reduced.  This is not to say that merchants will not pass-through some portion of any reduction in merchant discount fees; even a monopolist would find it profitable to lower prices if its input costs fell.  But I believe it is implausible that an expectation of higher margins is not an important part of the merchants’ interest in lower interchange fees.  Put differently, if it were really the case that merchants would quickly and completely pass-through any reduction in merchant discount fees, it seems unlikely that merchants would be fighting as hard as they have been fighting for lower interchange fees.

Note that, contrary to the claim that is sometimes made, it is not the case as a matter of economic theory that competition will necessarily ensure quick and complete pass-through of changes in input costs.  Even in a textbook model of perfect competition, an increase or decrease in input costs will not be passed through fully to consumer prices unless the industry has constant marginal costs.  In real-world industries of oligopoly and differentiated products, the economics of pass-through are even more complicated.

3.  A reduction in interchange fees will lead to increases in cardholder fees and/or reductions in card benefits (e.g. the value of reward programs).

I would be surprised if there was any argument about this proposition.  The evidence from Australia showed seemingly unambiguously that the reductions in interchange fees mandated by the RBA resulted in material increases in cardholder fees and material reductions in the value of reward programs.

4.  The government-mandated reduction in interchange fees in Australia did not appear to have any significant effect on the number of cardholders or card use.

In our paper summarizing the evidence from Australia, we pointed to possible factors that may have been operating in Australia at around the time of the RBA regulations and which may have obscured effects on card numbers and usage that otherwise would have been observed.  Even so, the evidence from Australia on card numbers and card use tends to support the view that, at least in a country such as Australia where card use is relatively “mature”, the demand to hold and use payment cards appears to be fairly inelastic.

5.  A reduction in interchange fees will reduce issuer profits.

Issuing banks tend to be opposed to regulatory efforts to limit interchange fees, which implies that issuing banks believe that such regulation would reduce their profits.  In theory, the opposition of issuing banks to interchange fee regulation could be due primarily to a concern that any significant reduction in interchange fees might trigger a “death spiral” (or, less colorfully, “negative network effects”).  However, if instead the demand to hold and use cards is relatively inelastic – which is what the Australian data tend to suggest is the case, at least for countries where card use is mature – then the opposition of issuer banks is less likely to be based on concerns about negative network effects and more likely to be based on concerns that a reduction in interchange fees will reduce issuer margins.

6.  The net effect of a regulatory reduction in interchange fees on the welfare of final consumers depends mainly on relative pass-through rates

The net effect of a reduction in interchange fees on the welfare of final consumers depends ultimately and mainly on relative pass-through rates – (1) the extent to which reductions in revenue from interchange fees on the issuing side are passed through to card holders in the form of higher cardholder fees and reduced card benefits relative to (2) the extent to which reductions in interchange fees on the acquiring side are passed through first to merchants in the form of reduced merchant discount fees and then on to consumers in the form of lower consumer prices and/or higher levels of service.

7.  If high interchange fees are the result of competition among schemes, the allegation of collusion seems misplaced.

As explained in the GAO report (and emphasized also by the RBA), interchange fees seem to be the result of competition among schemes.  In an environment in which merchant acceptance is not very sensitive to the level of merchant discount fees, competition among four-party schemes is likely to lead to higher interchange fees as the schemes use higher interchange fees as a tool to persuade issuers to issue and promote the usage of their particular scheme’s cards.  Against this backdrop, the suggestion by merchant organizations that they are the victims of collusion is curious.  If merchants are the “victims” of anything, it seems more accurate to describe them as the victims of competition in a two-sided market in which enough consumers on the other side of the market use only one card (“single homing”) that most merchants decide to accept all cards (“multi-homing”).  The same pressures for relatively high merchant discount fees would arise under these conditions even if all schemes were three-party schemes and there were no interchange fees.