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Understanding Interchange Fees

Jean-Charles ROCHETToulouse School of Economics

Prepared for the conference "The Economics of Payment Systems"ENST, Paris, October 25-26th, 2007

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Interchange Fees (IFs) have lately received a lot of attention fromRegulators, Competition Authorities, and Courts of Justice around the world.

Recent examples: • Australia (2002): regulation of IFs on credit cards by RBA.• UK (2003-2007): Antitrust action against MasterCard by OFT.• USA (2000-2007): several class actions. • Spain (2006): Competition Authority (TDC) “convinced" banks

to reduce IFs (from 1.80% to 1.40%)also Israel, Poland, Colombia, Portugal, Mexico and of course EU...

1- INTRODUCTION

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Introduction

IFs differ a lot across systems and across countries, both in their levels and in their formulas. An illustration:

Country Debit IF (average) Credit IF (average)

DenmarkFrance

IsraelItalySpainUK

0.4 %0.24 % + 0.1064 €+ Fraud Element

1.25 %0.119 % + 0.18 €

0.47 €0.64 £

0.75 %---

1.25 %0.75 %1.30 %1.10 %

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Economic research on the topic is very recent but already rich

Theory Schmalensee (2002)Rochet and Tirole (2002, 2006, 2007)Wright (2003, 2004), Gans and King (2003)McAndrews and Zhang (2006), Wang (2006)Farrell (2006), Guthrie and Wright (2007)

Bolt and Soramäki (2007),Verdier (2007)

Empirical Brits and Winder (2005), Klee (2006)Garcia-Schwartz, Hahn and Layne-Farrar (2006) Rysman (2007), Zinman (2007)Ching and Hayashi (2007), Snyder and Zinman (2007)

Bounie, François and Kiser (2007)

Introduction

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My objective here: to try and summarize in a non-technical fashion the pointsof views of practitioners and the implications of academic work.

What we know and what we don't know about IF

2- DOCTRINES (in italics)

3- FACTS (in boldface)

4- ECONOMIC ANALYSIS (open questions in red)

5- POLICY IMPLICATIONS

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2- DOCTRINES

2.1- Cards Systems / Banking Associations Viewpoint

“DOCTRINES” ARE PRESENTED IN ITALICS (please do not cite me on these statements)

Open card systems are joint ventures set up by banks (issuers and acquirers)

“IFs are interbank transfers that allow banks to share the costs of thesejoint ventures in a fair and efficient way”.

Two considerations:

• "fairness": equalize costs/and or profits

• "efficiency": maximize "value" of system.

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Doctrines

2.2- (Most) Competition Authorities’ Viewpoint

Card issuers incur some costs that benefit the customers of acquirers (the retailers).IFs are "fees for service" that compensate these costs. They should not exceed "admissible" costs of issuers.

System/ CountryTransactionAuthorizati

on/Processing

Fraud prevention/payment guarantee

Account Acquisition

Management, Maintenance and

fixed costs

Interest-free period

AustraliaUK (MasterCard)VISA InternationalFranceMexicoSwitzerland

yesyesyesyesyesyes

yesyesyesyes

partiallyyes

nonononoyesyes

yesnonononoyes

Costelementsincludedin the IFs

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2.3- Retailers' View Point

Retailers associations lobby for a reduction in their fees:

•“IFs are just a way to put the burden on us.• For commercial reasons, we (retailers) are often "forced" to accept

cards

("must take argument", Vickers 2005). •Banks inflate their profits by "taxing" us and subsidizing

cardholders

(air-miles, reward programs).•Each side should pay "its own costs".• IFs should be mandated at zero (cf "at par" regulation of US

checks)”.

Doctrines

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2.4- The Distortionary View

This view is often put forward by non economists who paradoxically

use an economic reasoning: user prices are a signal for guiding

consumer decisions

(but their way of applying this reasoning is sometimes flawed)

Interchange Fees generate several distortions in price signals• Retailers are forced to inflate retail prices to cover IF costs [ consumer welfare reduced when IFs are high].• Cash (and check?) consumers subsidize card users

[ abolish no surcharge rules].• Debit transactions subsidize credit transactions

[ "convenience users are parasites"].

Doctrines

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2.5- The Neutrality View

Theory shows that when retailers “perfectly” surcharge card payments, the level of IFs does not impact card usage (neutrality)

Gans and King (2003) and more recently Gans (2007, submission to the RBA review of payments system reforms) conclude :

Much ado about nothing: “there is no case for continued careful regulation of IFs” Provided the NDR is lifted, regulation of IFs has no benefits but costs (compliance and enforcement): thus it should be abolished

Based on empirical assessment of the RBA reform: Hayes(2007) finds no significant impact (partially contradicts Chang, Evans and Garcia Schwarz 2005).Even if there is indeed no impact on cards usage(?), the reform induced a massive redistribution between (issuers/cardholders and acquirers/merchants) .

Doctrines

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3- FACTS

Some facts (seem to) have been established empirically

3.1- IFs have an impact on user fees

IF reductions (increases?) are typically passed one for one into Merchant Service Charges (MSCs) but only partially into Cardholder Fees and Reward Programs.

Australia: IFs for credit were reduced roughly by half (0.80% to 0.44-0.46% for electronic, 1.20% to 0.60% for standard) while cardholders rewards were reduced roughly 25% and issuers income (cardholder fees) increased by roughly 40% (RBA 2005) Similar results in Portugal, even though there is a quasi monopoly for acquiring (UNICRE).In Australia, no sizeable impact on retail prices.

Open question for empirical research: are these findings robust?

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Facts

3.2- Users react to change in fees

Recent empirical work:• Zinman (2007): "pecuniary cost minimization account for at least 38 % of cross-sectional debit use over the period 1995-2004 (50 % for 2004).• Bounie, François and Kiser (2007).• Ching and Hayashi (2007).

But difficult to detect any change at aggregate level:• No sizeable decrease in credit card use in Australia (after RBA mandated a decrease in IFs).• Very often no unit fee nor reward on debit transactions.• Debit cards are often bundled with current account services.

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Facts

3.3- Fee Structure Matters

Closed systems like AMEX (that do not have explicit IFs)pay a lot of attention to their fee structure [empirical question:estimate these "implicit" IFs and compare with those of open systems].

Visa and MasterCard react to each other's changes in IFs(but competition does not always push IFs down).

After Honor All Cards rule was lifted (WalMart case 2003in the USA) IFs decreased for off line debit and increasedfor on line (PIN) debit.

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Facts

3.4- Evidence on Surcharging

Retailers are reluctant to surcharge: Netherlands, Sweden ITM (2000) Australia (RBA survey of 2279 merchants, June 2006)

But the threat of surcharging may be sufficient to curb down Ifs [empirical question].

corporate

commercial

SME

Micro Total

Currently surcharge %Average surcharge %

11.61.3

8.01.6

4.61.4

2.41.7

5.41.5

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Facts

3.5- Evidence on Multi-Homing

Rysman (2007), exploiting Visa PSPS data set on US consumershas shown that

• more than 50 % "multi-home" in membership (they own several cards)

• however they essentially use only one (single-homing in usage).

New results on this in this conference: Snyder and Zinman (2007)

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4.1- Usage Externality (Baxter)

4- ECONOMIC ANALYSIS

When a consumer pays by card instead of cash he inflictsthree externalities:

• the seller has to pay the MSC but saves the cost of Cash

• the issuer incurs a cost

• the acquirer incurs a cost but receives the MSC

Externality to merchant

Total externality (including banks)

SpSb

Bc

Sc Sp

S Sp b Sc b

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Social welfare is maximum when the consumer fee isequal to this total externality

Total user surplus (buyer + seller) is maximum when theexternality to the merchant is nil

(Farrell's indifference criterion).

Economic Analysis

Sc bBp

S Sp b

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Economic Analysis

If acquirers are perfectly competitive, the IF that maximizesTotal User Surplus is

TUS S Sa b c (Baxter)

cost of cashfor the seller

cost of cardfor the acquirer

The IF that maximizes social welfare is higher, since it includesissuers' margin

W S S Ia b c m

issuer margin

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Economic Analysis

4.2- Social Welfare VS User Surplus

Competition Authorities often care only about user surplus andnot about social welfare

• This is justified if the profit of firms (banks) is completely dissipated (business steeling, useless advertisements…)

• This is not justified if profit is reinvested to provide quality of service or attracts entry (lower prices, increased product variety).

Long Term User Surplus is maximized for a value of IF that isin between and TUSa .Wa

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Economic Analysis

4.3- Inter and Intra-system Competition

Intersystem competition tends to reduce IFs, but only if

sufficiently many cardholders multi-home.

By contrast, if most cardholders single-home (i.e. hold a single card),

merchants resistance to high MSCs is very weak

high IFs

[intersystem competition is ineffective = competitive bottleneck]

Empirical measurement of multi-homing is crucial: Snyder-Zinman (2007)

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Economic Analysis

By contrast, if most cardholders have several cards, it isless costly for merchants to reject one of them low IFs.(close to Total User Surplus maximum )TUSa

Competitive IF is in between (complete multi-homing)

and (monopoly or competitive bottleneck)

[open question] US enigma: competition for issuers increase in IFs

TUSaCa

ma

maCaTUSa Wa

W (Social Welfare)

TUS (Total User Surplus)

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Economic Analysis

Intra-system competition drives down banks‘ margins andtherefore total user price

The impact on IFs is less clear

B Sp p c m Banks’ margin

C S S

m S S B

a b c

a b c vQuality of Service (increaseswhen issuer margin decreases)

independent of issuer margin

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Economic Analysis

4.4- Debit VS Credit

So far, theory has paid too little attention to the substitutabilitybetween credit and debit.

Recent empirical work: Zinman (2007), Ching and Hayashi (2007),Bounie, François and Kiser (2007) indicate that consumerspayment choice is price elastic (rewards, credit charges).

On going theoretical work (Rochet and Wright, in preparation)suggest that networks might be inclined to distort IFs so as toencourage credit use.

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5- POLICY IMPLICATIONS

• Systems may be inclined to set excessively high IFs (this is because banks' profits seem to increase with level of IF) IS THIS A ROBUST FINDING?

• However, regulating IFs would be a delicate exercise, because substitutability between different means of payments and long term reactions of the industry are difficult to assess. NEED TO MODEL/MEASURE SUBSTITUTABILITY BETWEEN MEANS OF PAYMENT AND LONG TERM REACTIONS OF SYSTEMS

• Allowing surcharges might be a way to curve IFs down but it will not be a panacea. NEED TO MEASURE IMPACT OF ALLOWING SURCHARGES ON (NON REGULATED) IFS

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5- POLICY IMPLICATIONS

• The conflicts of interests in payment card systems have been largely exaggerated: merchants indirectly benefit from the additional Quality Of Service provided by the option to pay by card offered to their customers. Even if retailers associations legitimately lobby to reduce their fees, it is not their interest to go too far.

• There is a wide perception that inflating IFs allow banks to obtain supra competitive profits. This may be due to an asymmetric pass through of IFs changes into the two user prices. Competition Authorities have to find a way to avoid excessive IFs.

• A “pragmatic” suggestion: organizing "IF observatories" with representatives of retailers and consumers associations. In these IFOs, card systems would disclose their methodologies for setting Ifs, communicate (average) data on issuing and acquiring costs, and “advocate” for their IF decisions.