the melbourne review
Where to next on credit card reforms?
Joshua Gans and Stephen King
Australia has engaged in a unique experiment in
credit card reform, which has included capping
and cutting the interchange fee. Our experience
from this reform indicates that the RBA can
now safely avoid the costs of ongoing regulatory
intervention by setting the interchange fee at a
desired level and leaving the market to itself.
42
Vol 4 Number 1 May 2008
T
he number of credit and
charge card accounts in
Australia has increased by
around 5 per cent in the past year to
almost 14 million. About $17 billion
worth of transactions per month
involve credit or charge cards, with
debit cards accounting for around
another $7 billion in monthly
purchases.1
 the melbourne review
Since 2002 the Reserve Bank of
Australia (RBA) has imposed a
variety of regulatory reforms on the
card systems. These include capping
the ‘interchange fee’ that is payable
on debit and credit cards, opening
up access to the card schemes and
the EFTPOS system, and banning
certain rules that previously applied
to merchants who accepted cards,
such as the no-surcharge rule and the
honour-all-cards rule.
These reforms have been significant.
For example, before the RBA
intervened, the average interchange
fee on credit card transactions
was around 0.95 per cent. This is
currently capped at 0.50 per cent
— nearly half the pre-reform level.
The reforms to credit cards have been
strongly supported by merchants,
who bear the direct impact of the
interchange fee, and strongly opposed
by the banks and card schemes.
The RBA is currently reviewing
these regulations to determine their
effect and to consider whether or
not they should continue.2 In this
article we briefly summarise the
economic principles underpinning
card regulations. For simplicity, we
focus on so-called ‘four party’ credit
card systems although similar issues
apply to debit cards. We consider the
effects of the regulations imposed
by the RBA and how they might be
modified in future.
What is the problem?
Card systems generally involve four
parties: a customer or card holder, a
merchant who is selling something
to the customer and who is willing to
accept the card as payment, the bank
that issues the card to the customer
(the issuer), and the bank that
services the merchant (the acquirer).
Payments move between these
parties when the customer uses the
card to make a purchase.
The customer pays the merchant for
what they buy, while, for a credit
card transaction, the merchant pays
a service fee to the acquirer. The
acquirer pays an interchange fee to
the issuer. The customer may also
pay the issuer for the card, or be paid
by the issuer, for example, through
The RBA’s primary concern related to the interchange
fee that was charged between the issuing and
acquiring banks. It argued that these fees for credit
card transactions were too high and were not subject to
competitive forces.
loyalty points based on the value of
the transaction. Traditionally, the
merchant has been subject to a no-
surcharge rule imposed by the card
scheme, meaning that the merchant
had to offer the same price to a card
customer as it offered to a cash
customer despite facing different
costs and benefits with these different
payment instruments.
Vol 4the melbourne
Number 1 May 2008review
The RBA’s primary concern related to
the interchange fee that was charged
between the issuing and acquiring
banks. It argued that these fees for
credit card transactions were too high
and were not subject to competitive
forces. While the RBA recognised
that restrictions on surcharges for
card transactions could also limit
competition between payment
instruments, and required their
removal, it did not think that this
fully addressed the interchange fee
problem. As a result, the RBA capped
the interchange fee.
There are good economic reasons
why the interchange fee that is set
in the market may not be at the
socially optimal level. Card systems
represent what economists call
‘two-sided’ markets. In a normal
one-sided market a customer simply
approaches a retailer who sells the
good they desire to purchase. The
retailer will have purchased the good
from a wholesaler, who, in turn,
would have purchased the good from
an upstream supplier, and so on back
to the manufacturer. There is a linear
chain of transactions that turns the
basic inputs into a product delivered
to the customer.
Two-sided markets involve
transactions that are moderated
through central organisations
and provide benefits to a variety
of customers simultaneously. For
43
 the melbourne review Vol 4 Number 1 May 2008

example, a media company brings choice of payment instrument has interchange fee allows the ‘net
together viewers or readers and implications for the merchant. If external benefit’ from the choice of a
advertisers. The advertisers pay payment instrument A is cheaper payment instrument to be transferred
the media company to show their from the merchant’s perspective than to the customer. The customer
advertisements but this payment payment instrument B, then the will then face the socially optimal
usually depends on the number of merchant would prefer the customer incentive when choosing a payment
viewers. The viewers buy a product to choose A rather than B. In the instrument.
from the media company, not for the absence of either a price differential
advertisements in general, but for on the final product that depends on 2. Under a no-surcharge rule, there is no
other content. But they are exposed the choice of payment instrument
reason to expect that the market will set the
to the advertising as part of their (i.e. a surcharge) or an interchange
optimal interchange fee.
viewing. So the media company fee, the customer will simply choose A variety of factors comes into play
moderates a two-sided interaction a payment instrument according to when banks set the interchange
between viewers and advertisers and fee for a card system. If the fee
their own costs and benefits.
sets prices that seek to balance the is set too high, this will raise the
interests of these two groups.3 The externality created by the merchant services fee and discourage
customer through their choice merchants from accepting the card.
A credit card similarly requires
of payment instrument can be If the interchange fee is set too low,
coordination between card holders
internalised either by a surcharge then the issuer bank may have
and merchants. A credit card is of
or through the interchange fee. In little incentive to promote the card
little use to a customer if it is not
the absence of surcharging, the to customers and customers will
accepted by many merchants, while
a merchant has little incentive to
accept a card that is not held by many
customers. The banks involved in a
four-party credit card scheme need
to balance the prices they charge
customers and merchants to ensure
that both groups have appropriate
incentives to hold and accept the
card. These prices may not reflect
simple ‘costs’ and some prices may
be negative — such as when a card
customer receives reward points.

The economics of two-sided markets

can be complex but, for credit
cards, the main messages can be
summarised as follows:

1. Credit cards involve a ‘choice of payment

instrument’ externality.
When a customer chooses to
purchase a product from a merchant
who accepts multiple payment
instruments, the actual choice of
payment instrument is made by the
customer. However, the customer’s

44
 the melbourne review
have little incentive to use the card.
Competition among both issuers and
acquirers can affect the interchange
fee, as can the existence of competing
payment instruments. However, even
if there are a number of strongly
competing card systems, the market
need not establish the economically
optimal interchange fee.
This result is unsurprising. After all,
we do not expect other markets where
externalities exist to automatically
reach an optimal price, regardless
of the degree of competition. For
example, if there is a negative
externality like pollution, we expect
a competitive market to set the price
for the relevant end product at a level
that is too low (i.e. which does not
take into account these costs). That is
one of the reasons why governments
intervene in markets where there are
strong externalities.
The externality created by the ‘choice
of payment instrument’ means that
even competitive cards markets are
unlikely to set optimal prices. Both
the degree of market failure and its
direction can depend on a variety of
factors. For example, multi-homing
— where customers tend to carry a
variety of cards and merchants can
limit the range of cards they accept
without fear of losing many sales
— can help markets to set prices that
more accurately reflect true costs. In
this situation, merchants can at least
partially reflect the costs that they
face through the choice of payment
instrument by not accepting cards
that are ‘too costly’. This helps offset
the externality. But the general
result still holds — the market is
unlikely to set the ‘right’
interchange fee.
3. If there is perfect surcharging, the
interchange fee is irrelevant.
If merchants impose a surcharge
on the basis of the specific payment
instrument used by a customer, the
actual interchange fee is irrelevant.
The merchant simply passes the
costs of the payment instrument
on to the customer through the
surcharge so that a rise in merchant
fees (possibly due to a rise in the
The economic principles underpinning credit card
markets suggest that there is likely to be an economic
problem with interchange fees for credit cards when
there is also a no-surcharge rule on merchants. But this
does not imply that regulation of the interchange fee is
the solution.
interchange fee) is simply reflected
in a higher surcharge. The reason for
this is simple. If merchants impose
a surcharge, there is essentially a
redundant price involved with the use
of a payment instrument. Any change
in the interchange fee can simply
be ‘undone’ by changes in the mix
of the surcharge, the merchant fees,
and the customer card fees. While
surcharging makes the interchange
fee irrelevant, even with perfect
surcharging there may be a ‘problem’
of pricing for payment instruments.
However, this problem cannot be
addressed through regulation of the
interchange fee.
Is regulation the solution?
The economic principles
underpinning credit card markets
suggest that there is likely to be an
economic problem with interchange
fees for credit cards when there
is also a no-surcharge rule on
Vol 4the melbourne
Number 1 May 2008review
merchants. But this does not imply
that regulation of the interchange fee
is the solution.
The obvious implication is that,
to the extent that the level of
the interchange fee is a concern
for regulators, removing the no-
surcharge rule should help to
overcome this problem. The RBA
agrees with this but also believes that
the removal of the no-surcharge rule
by itself will not fix the interchange
fee problem. As Philip Lowe,
Assistant Governor of the RBA,
noted:
In thinking about appropriate
regulatory responses to these
distorted price signals, the RBA
considered simply requiring
that the no-surcharge rule
be removed, thus allowing
merchants to charge customers
using a credit card a higher price.
… We saw considerable merit in
this approach, and have in fact
required that the no-surcharge
rule be removed from merchant
contracts. However, our view has
been that removing this rule was
not enough, by itself, to establish
more appropriate price signals to
cardholders.4
The regulatory problem, however,
is that any explicit regulation of
the interchange fee will either be
uncertain or useless. If the removal of
45
 the melbourne review
the no-surcharge rule works so that
close-to-perfect surcharging emerges,
any further regulation of the
interchange fee is irrelevant. But in
the absence of perfect surcharging, it
is impossible for a regulator to know
exactly what the correct interchange
fee should be.
The RBA’s current approach to
capping interchange fees on credit
cards is explicitly cost-based. This
reflects standard approaches to
regulation in one-sided markets,
but it is not clear that a cost-based
approach is correct in a two-sided
market. After all, in a two-sided
market, any division of ‘system costs’
between the different sides of the
market will be arbitrary. While a
cost-based approach may correctly
internalise the payment externality,
this will only occur under certain
specific conditions.5 More generally,
it is not clear that a regulated cost-
based interchange fee will be either
better or worse than the fee set by
the market.
46
Vol 4 Number 1 May 2008
is difficult to determine the exact
size of these changes as they include
non-monetary components. However,
other than these, the RBA reforms
seem to have had little real effect on
the payments system.
Since October 2003—the month the
interchange fee was cut—there has
not been any discernible change in
the use of credit cards. The following
graph (figure 1) is representative.
Credit and charge card purchases
have continued to grow. The same
is true of credit card debt and the
number of credit cards held by
Australians.
Richard Hayes has used sophisticated
econometric techniques to understand
Of course, the ultimate test of the
trends in the credit card industry.6
RBA’s regulatory cap on interchange
While even modest interest rate
fees is its effects in practice. What
rises can drive down credit card
has occurred as a result of the RBA’s
transactions, the more dramatic
payments system reforms?
The RBA’s current approach to capping interchange
fees on credit cards is explicitly cost-based. This
reflects standard approaches to regulation in one-sided
markets, but it is not clear that a cost-based approach
is correct in a two-sided market. After all, in a two-
sided market, any division of ‘system costs’ between the
different sides of the market will be arbitrary.
Were the regulations effective? changes in interchange fees have not
had statistically significant effects.
The package of reforms to card
systems introduced by the RBA The apparent lack of effect of the
clearly affected the credit card RBA regulations on credit card usage
market. The reduction in interchange to date suggests that either allowing
fees led to an almost identical fall surcharging makes the interchange
in the average merchant services fee largely irrelevant or that, given
fee. There appears to have been a the history of interchange fee
reduction in benefits paid by card stability in Australia, the interchange
schemes to consumers, although it fee was a poor choice of regulatory
 the melbourne review Vol 4the melbourne
Number 1 May 2008review

Figure 1: Value of Credit and Charge Card Purchases ($m) paper, the RBA canvasses
the possibility of setting all
interchange fees to zero.
18000 18000
• Does the lack of effect mean that
16000 16000
the RBA should remove the price
14000 14000
cap? Unfortunately, perhaps,
12000 history matters and there 12000
is
10000 no guarantee that removing 10000
the existing interchange fee
8000 8000
regulation will return the market
6000 6000
to the relatively benign stable
4000 4000
interchange fee that previously
2000 existed in Australia. 2000

0 • Should the RBA retain the0

May–2001
Dec–2001

Mar–2007
Jul–2002
May–1994

Apr–1997

Mar–2000

Feb–2003

Jan–2006
Aug–2006
Dec–1994

Nov–1997

Oct–2000
Jun–1998

Nov–2004
Jan–1999
Sep–1996

Aug–1999

Jun–2005
Sep–2003
Apr–2004
Feb–1996
Jul–1995

current cost-based methodology,

and simply continue with the
existing regulation? To the extent
that the current regulations
Source: Reserve Bank of Australia.
appear to have done no harm,
it can be argued that they are
variable. As noted above, if there is What next? at worst benign and should be
perfect surcharging, the interchange
The lack of impact of the current continued. But such an argument
fee is irrelevant, and its regulation
RBA interchange fee regulations on fails to recognise the real ongoing
will have no real effect. However,
credit card usage raises a series of regulatory burden associated
surcharging does not appear to be
questions: with cost-based regulation. As
perfect in Australia and it still only
• Does this lack of effect mean we have seen in other industries,
applies to a very small share of credit
that the regulation is not strong such as telecommunications,
card transactions.
enough? In its May 2007 issues ongoing cost-based regulation
Alternatively, the RBA may simply
be regulating the wrong thing. Prior
to RBA intervention, the interchange
fee on credit cards had been stable
over a long period. Interchange fees
did not appear to be systematically
manipulated by the card systems or
the banks in order to exploit market
power. Rather, it appeared that the
banks had used a ‘set and forget’
strategy for the interchange fee, with
the fee remaining at 0.95 per cent
despite significant changes to both
payments systems and the economy
in general. This may simply reflect
the fact that the exact level of the
interchange fee is not important for
the operation of credit card schemes.7

47
 the melbourne review Vol 4 Number 1 May 2008

us to conclude that the RBA can
safely avoid the costs of ongoing
regulatory intervention by setting the
interchange fee, once and for all, at a
desired level and otherwise leaving
the market to itself. ■
way that favours their particular
interests. At the aggregate level
the reforms may have had little
effect but there may still be
transfers associated with the
regulations.

ENDNOTES Joshua Gans

can be contentious and result
in an expensive ‘war’ between
competing economic models
to determine the correct costs.
It may also lead to distorted
production decisions as parties
try to manipulate the cost-based
formula used by the regulator.
• Should the RBA simply keep
the current fee cap but not try
to justify it as cost-based? If the
current cap is benign but its
removal may have undesirable
consequences, simply retaining
the current cap may be an
appropriate regulatory solution.
Effectively, the RBA would
thereby be mimicking the ‘set
and forget’ strategy that the
banks themselves appear to have
adopted prior to regulation.
1
All data are available on the Joshua Gans is Professor of
Reserve Bank of Australia Management (Information
Payments System website. Economics) at the Melbourne
2
The RBA released an issues paper Business School and has testified
for the 2007–08 review in May before Australian parliamentary
2007. committees on issues of credit card
reform. Email: j.gans@mbs.edu
3
For a discussion of two-sided
markets in the context of the
Stephen King
media see Simon Anderson and
Joshua Gans 2006, ‘What is Stephen King is a former MBS
Different about Media Mergers?’, professor and now a Commissioner
The Melbourne Review, vol. 2, at the Australian Competition and
no. 2, November, pp. 32–36. Consumer Commission.
Email: stephen.king@accc.gov.au
4
P. Lowe 2005, ‘Payments
System Reform: the Australian Joshua Gans and Stephen King
experience’, in Interchange have studied the economics of the
Fees in Credit and Debit Card credit card industry together with a
Industries: What Role for Public series of articles dating back to 2001
Authorities?, an international (see www.core-research.com.au for
payments policy conference details). The views expressed in this
sponsored by the Federal Reserve paper do not necessarily reflect those
Bank of Kansas City, May 4–6, of the ACCC.
FRB (Kansas City) at p. 271.
5
Joshua Gans and Stephen P. King
2003, ‘A Theoretical Analysis of
Credit Card Reform in Australia,’
Economic Record, vol. 79, no. 247,
December, pp. 462–472.

Australia has engaged in a unique

experiment in credit card reform.
To the extent that these reforms,
including capping and cutting the
interchange fee, have not changed
much in the industry, the experiment
suggests that continued interventions
may be very costly in terms of
their ongoing regulatory burden.
Experience with this reform leads
6
Richard Hayes 2007, ‘An
Econometric Analysis of the
Impact of the RBA’s Credit
Card Reforms,’ mimeo., August,
Melbourne Business School.
7
However, the banks, schemes
and merchants have all expended
considerable time and effort
trying to influence the RBA to
move the interchange fee in a

48