Credit cards

Should the payment card industry be a free market? Or does it need to be regulated? The debate is raging in countries across the world, with both retailers and card issuers arguing that tweaks to interchange fees and leaving them shortchanged.

Retailers and card issuers are at loggerheads over interchange fees in a battle that puts billions of dollars at stake and goes right to the heart of whether the payment card industry is a free market or whether it needs regulatory intervention.

Interchange fees, which are paid by the merchant’s bank to the cardholder’s bank every time a card is used, has long been contentious. Merchants have been vocal – and successful – in lobbying for intervention in the industry, which has taken different forms in markets around the world.

The latest round of the battle is being fought in the US, where the Federal Reserve is poised to cap the interchange fee for debit transactions to $0.12, a reduction of approximately 70%.

No winners

In this business-to-business battle each side feels that they are, or will be, shortchanged. The US-based National Retail Federation (NRF) estimates that credit and debit card fees cost retailers about $50bn a year, and the reforms, which were scheduled to go into effect in July 2011, will amount to approximately $14bn a year in savings. This would mean a significant loss of revenue for the banks that issue payment cards. Bank of America, for example, estimated in a quarterly filing that it could lose between $1.8bn and $2.3bn a year as a result of the intervention.

Large and small banks alike are up in arms over the proposed regulation. Camden R Fine, president and CEO of Independent Community Bankers of America, says: “It allows the government for the first time in American economic history to actually fix the price of a fairly traded private product… It is a terrible precedent – that is why the bankers are so upset.”

Retailers are also upset, and argue that interchange fees are a hidden tax on consumers. “Banks have enjoyed this multi-billion revenue stream for many years free of scrutiny because the fees don't show up on either cash register receipts or cardholders' monthly bills. Now that attention has been called to the huge amount banks are charging consumers to use their credit and debit cards, Congress has moved to bring these fees under control and the banks are upset that they are being forced to compete in the open marketplace,” says J Craig Shearman, vice-president for government affairs public relations at the NRF.

It is not just the lost revenue that is at stake. Banking executives feel that they are being shortchanged because they are the ones that have developed the payment system. Mr Fine says: “The banks invested in the software, the technology, the fraud prevention technology, the machines, the plastic cards – the actual cards – all of that cost is borne by the banks and that system has been developed over a 25-year period. It has cost the banking industry billions of dollars. The merchants did not pay for that system.”

Broken market?

The main grievance of retailers, however, is that the market is broken because it is structured in such a way that retailers cannot negotiate the fees.

The economics of the interchange system are unique in the sense that the user – the cardholder – does not pay, and the recipient – the issuing bank – does not set the fees. The payment networks, such as Visa and MasterCard, are the ones that set the interchange fees although they receive no interchange revenue. They function as a middle man connecting the four parties of the card system – the cardholder, the issuing bank, the merchant and the merchant acquiring bank – so that the payment is taken from the cardholder’s account and transferred across the network to the merchant’s bank account.

The average cardholder at the point of sale does not know the difference in cost of different payment methods. In the consumer’s mind there may be no difference between paying by cash, credit or debit, and they may be motivated by the rewards and bonus points that they get for using their credit card. This comes at a cost to the merchant, who has to pay higher interchange rates on premium products, which reap higher revenue for the issuing bank. Another problem area is that the merchants typically do not have a direct relationship with the networks, and therefore cannot negotiate the fees, as they are billed by the merchant acquirer who includes interchange as part of the merchant service charge.

Eric Grover, principal of consultancy Intrepid Ventures, points out that anti-trust issues have been another area of concern as Visa and MasterCard – prior to their initial public offerings – were closed bank-owned associations. Merchants have depicted this set-up as a cartel where the same banks were sitting on the boards of both networks and setting the fees, which they would ultimately benefit from.

Price-fixing has been the focus of class action lawsuits against Visa and MasterCard in the US. Now, however, the debate over interchange has moved to the political arena.

Cost recovery debate

The debate in the US has been framed around cost recovery and that the Federal Reserve will regulate interchange in a way that is “reasonable and proportional” to the costs incurred by the issuer for the transaction.

Mr Grover, however, argues that interchange has nothing to do with cost and is a balancing act to incentivise both consumers and merchants to use payment cards. If, for example, interchange is high, consumers will be encouraged to use the cards because of the rewards, but if the pricing is too high merchants will refuse to accept the cards. The pricing aims to keep equilibrium between both sides of the market, ie. the usage by the consumer and the acceptance by the merchant. “Interchange is really set by the networks to maximise transactions, irrespective of costs,” says Mr Grover.

The debate has taken different forms in other markets, although the dispute is still between vocal merchant lobby groups and the defensive payments industry. In Australia, which is widely viewed as the test case of regulating interchange fees, the country's central bank introduced a number of sweeping changes. In reforms that were announced in 2002, the Reserve Bank of Australia capped the interchange for credit cards at 0.5%, and also allowed retailers to surcharge to cover the cost of interchange fees. The regulators took action because they viewed the market as inefficient, arguing that in a healthy market the cheapest option – ie. debit – should be the most popular. That was not the case, and so the interchange pricing was changed to encourage consumers to use Eftpos – Australia’s domestic debit scheme – and drive down credit card usage.

Zilvinas Bareisis, senior analyst at research and consultancy firm Celent, says that there are subtle differences in the language that regulators use when addressing interchange. In US the debate has been focused on the processing costs, whereas in Europe it is about ensuring competition. In Europe, unlike Australia and the US where regulation has been applied to interchange, it is competition law that has been used to take action against interchange fees.

EC action

The European Commission (EC) has taken action against Visa and MasterCard on the basis of competition concerns. In 2007, the EC banned MasterCard’s cross-border interchange fees on the basis that they inflated prices for retailers and there were no proven efficiencies in the system as a result of the fees. MasterCard is appealing the decision. The European regulator takes the perspective that Europe should be a single market where pricing structures should be the same in all countries in the European Economic Area, and so cross-border interchange was problematic because it was at a different rate to domestic transactions.

Visa Europe has also been under the spotlight of the EC, which also views that it restricts competition between banks and merchants, and in 2010 Visa Europe proposed to reduce its cross-border interchange for debit transactions to 0.2%.

The approach has been different in Europe as the intervention is based on a principle of merchant indifference, whereby interchange should be set at a level at which the merchant is indifferent to whether the customer pays with cash or a card.

The arguments for the differing approaches to intervention are complex, as are the debated consequences of such action. Many cite the example of Australia to argue their case. For example, the banking industry argues that consumers did not benefit from the interchange reduction – and ability of merchants to surcharge – in the form of lower retail prices.

Russell Zimmerman, executive director of the Australian Retailers Association, describes such arguments as “hogwash”. Mr Zimmerman, who was one of the key players in lobbying for the interchange reforms in his role as chair of the Australian Merchant Payments Forum, argues that it was never expected that retail prices would come down, and it is not possible to isolate the interchange saving in this way. “Retailers always have increases: the cost of rental, the cost of insurance, the general operating costs are always increasing,” he says, adding that because retailers are in a competitive environment they are driven to keep their prices low.

Small guys suffer

Bankers in the US, however, continue to argue that it is retailers who will benefit from the anticipated regulations and not consumers. Michael Grant, president of the National Bankers Association, says: “Two per cent of retailers will receive more than 80% of the $15bn windfall if this new debit card rule goes into effect. Meanwhile, small financial institutions such as community banks and credit unions will see a dramatic loss of resources needed to operate debit card programmes. Many will have to raise rates on services that are now free, or possibly stop issuing debit cards altogether.” 

Owners of credit unions and community banks in the US argue that they will be the most negatively affected by such changes and will no longer be able to offer free checking accounts for underserved segments. Mr Grant adds: “Banks are able to provide services to the underbanked because of the revenue generated from interchange.”

Fred R Becker Jr, president and CEO of the National Association of Federal Credit Unions, says: “This is a transfer of revenue from the financial services industry to the big-box retailers. There is no consumer benefit. The merchants are not required to in any way reduce their cost as a result of the savings. They will continue to benefit… Credit unions are about serving their members with low fees and low loan rates. This is taking the money out of the hands of consumers and transferring it to the big-box retailers.”

Call for clarity

It may not just be the retailers who will pocket the savings from any interchange reduction. Bob Baldwin, president of merchant acquirer and processor Heartland Payment Systems, says that smaller retailers may lose out because the acquirers, who add interchange fees into the merchant service charge, may not pass on the savings to their customers. He argues that the large retailers have enough clout to lobby and negotiate lower fees, but it is the rights of small business owners that are often overlooked. Mr Baldwin comments on the lack of transparency in the industry in how merchants are billed for payment card fees.

Heartland aims to tackle this problem with its Merchant Bill of Rights initiative that calls for clarity in billing and will communicate with merchants the savings they can expect to see if the interchange regulation goes into effect. Mr Baldwin says that Heartland would pass on the savings to its merchants, but argues that some of his competitors may not.

Consequences such as these are possible as one tweak in the system can affect the other parties. As retailers and the banks continue to wrangle over the details, any kind of compromise looks unlikely. In the battle over whether the payments industry is a free market, or whether it needs to be regulated, retailers and banks continue to argue about who will be shortchanged, and who will pocket the difference, from any change in the pricing of interchange fees.

 

Four-party system

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