You are on page 1of 7

the melbourne review

Vol 4 Number 1 May 2008

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

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

the melbourne Vol 4 Number 1 May 2008review

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.

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. 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

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 nosurcharge 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. 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

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

43

the melbourne review

Vol 4 Number 1 May 2008

example, a media company brings together viewers or readers and advertisers. The advertisers pay the media company to show their advertisements but this payment usually depends on the number of viewers. The viewers buy a product from the media company, not for the advertisements in general, but for other content. But they are exposed to the advertising as part of their viewing. So the media company moderates a two-sided interaction between viewers and advertisers and sets prices that seek to balance the interests of these two groups.3 A credit card similarly requires coordination between card holders and merchants. A credit card is of little use to a customer if it is not 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:

choice of payment instrument has implications for the merchant. If payment instrument A is cheaper from the merchant’s perspective than payment instrument B, then the merchant would prefer the customer to choose A rather than B. In the absence of either a price differential on the final product that depends on the choice of payment instrument (i.e. a surcharge) or an interchange fee, the customer will simply choose a payment instrument according to their own costs and benefits. The externality created by the customer through their choice of payment instrument can be internalised either by a surcharge or through the interchange fee. In the absence of surcharging, the

interchange fee allows the ‘net external benefit’ from the choice of a payment instrument to be transferred to the customer. The customer will then face the socially optimal incentive when choosing a payment instrument.

2. Under a no-surcharge rule, there is no reason to expect that the market will set the optimal interchange fee.
A variety of factors comes into play when banks set the interchange fee for a card system. If the fee is set too high, this will raise the merchant services fee and discourage merchants from accepting the card. If the interchange fee is set too low, then the issuer bank may have little incentive to promote the card to customers and customers will

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

the melbourne Vol 4 Number 1 May 2008review

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

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 nosurcharge rule should help to overcome this problem. The RBA agrees with this but also believes that the removal of the no-surcharge rule

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. 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

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

45

the melbourne review

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 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 costbased interchange fee will be either better or worse than the fee set by the market. Of course, the ultimate test of the RBA’s regulatory cap on interchange fees is its effects in practice. What has occurred as a result of the RBA’s payments system reforms? econometric techniques to understand trends in the credit card industry.6 While even modest interest rate rises can drive down credit card transactions, the more dramatic

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 twosided market, any division of ‘system costs’ between the different sides of the market will be arbitrary.

Were the regulations effective?
The package of reforms to card systems introduced by the RBA clearly affected the credit card market. The reduction in interchange fees led to an almost identical fall in the average merchant services fee. There appears to have been a reduction in benefits paid by card schemes to consumers, although it

changes in interchange fees have not had statistically significant effects. The apparent lack of effect of the RBA regulations on credit card usage to date suggests that either allowing surcharging makes the interchange fee largely irrelevant or that, given the history of interchange fee stability in Australia, the interchange fee was a poor choice of regulatory

46

the melbourne review

the melbourne Vol 4 Number 1 May 2008review

Figure 1: Value of Credit and Charge Card Purchases ($m)
18000 16000 14000 12000 10000 8000 6000 4000 2000 May–2001 Dec–2001 0 May–1994 Apr–1997 Mar–2000 Nov–1997 Dec–1994 Jun–1998 Oct–2000 Jan–1999 Aug–1999 Sep–1996 Feb–1996 Jul–1995 Nov–2004 Aug–2006 Sep–2003 Mar–2007 Jul–2002 Feb–2003 Apr–2004 Jun–2005 Jan–2006

paper, the RBA canvasses the possibility of setting all interchange fees to zero.

18000

• Does the lack of effect mean that 16000 the RBA should remove the price 14000 cap? Unfortunately, perhaps, history matters and there 12000 is no guarantee that removing 10000 the existing interchange fee 8000 regulation will return the market 6000 to the relatively benign stable 4000 interchange fee that previously existed in Australia. 2000 • Should the RBA retain the 0 current cost-based methodology, and simply continue with the existing regulation? To the extent that the current regulations appear to have done no harm, it can be argued that they are at worst benign and should be continued. But such an argument fails to recognise the real ongoing regulatory burden associated with cost-based regulation. As we have seen in other industries, such as telecommunications, ongoing cost-based regulation

Source: Reserve Bank of Australia. variable. As noted above, if there is perfect surcharging, the interchange fee is irrelevant, and its regulation will have no real effect. However, surcharging does not appear to be perfect in Australia and it still only applies to a very small share of credit card transactions. 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

What next?
The lack of impact of the current RBA interchange fee regulations on credit card usage raises a series of questions: • Does this lack of effect mean that the regulation is not strong enough? In its May 2007 issues

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
1

Joshua Gans
Joshua Gans is Professor of Management (Information Economics) at the Melbourne Business School and has testified before Australian parliamentary committees on issues of credit card reform. Email: j.gans@mbs.edu

All data are available on the Reserve Bank of Australia Payments System website. The RBA released an issues paper for the 2007–08 review in May 2007. For a discussion of two-sided markets in the context of the media see Simon Anderson and Joshua Gans 2006, ‘What is Different about Media Mergers?’, The Melbourne Review, vol. 2, no. 2, November, pp. 32–36. P. Lowe 2005, ‘Payments System Reform: the Australian experience’, in Interchange Fees in Credit and Debit Card Industries: What Role for Public Authorities?, an international payments policy conference sponsored by the Federal Reserve Bank of Kansas City, May 4–6, FRB (Kansas City) at p. 271. 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. Richard Hayes 2007, ‘An Econometric Analysis of the Impact of the RBA’s Credit Card Reforms,’ mimeo., August, Melbourne Business School. 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

2

3

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. 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

Stephen King
Stephen King is a former MBS professor and now a Commissioner at the Australian Competition and Consumer Commission. Email: stephen.king@accc.gov.au Joshua Gans and Stephen King have studied the economics of the credit card industry together with a series of articles dating back to 2001 (see www.core-research.com.au for details). The views expressed in this paper do not necessarily reflect those of the ACCC.

4

5

6

7

48