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the melbourne review Vol 4 Number 1 May 2008

42

Where to next on credit card reforms?

Joshua Gans and Stephen King

Australia has engaged in a unique experiment incredit 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.

The 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

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the melbourne reviewVol 4 Number 1 May 2008the 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 theireffect 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

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.

The RBAs 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 setin 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 linearchain 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

The RBAs primary concern related to the interchangefee 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.

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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:

1. Credit cards involve a choice of paymentinstrument 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 customers

choice of payment instrument has

implications for the merchant. If

payment instrument A is cheaper

from the merchants 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 thecustomer 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 noreason to expect that the market will set theoptimal 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

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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 negativeexternality 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, theinterchange fee is irrelevant.

If merchants impose a surcharge

on the basis of the specific paymentinstrument 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

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

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 hasbeen 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

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.

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46

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 RBAs 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 acost-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.

Of course, the ultimate test of the

RBAs regulatory cap on interchange

fees is its effects in practice. What

has occurred as a result of the RBAs

payments system reforms?

Were the regulations effective?

The package of reforms to cardsystems 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

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 2003the month the

interchange fee was cutthere 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

trends in the credit card industry.6

While even modest interest rate

rises can drive down credit card

transactions, the more dramatic

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

The RBAs current approach to capping interchangefees 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.

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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 meanthat the regulation is not strong

enough? In its May 2007 issues

paper, the RBA canvasses

the possibility of setting all

interchange fees to zero.

Does the lack of effect mean thatthe RBA should remove the price

cap? Unfortunately, perhaps,

history matters and there is

no guarantee that removing

the existing interchange fee

regulation will return the market

to the relatively benign stable

interchange fee that previously

existed in Australia.

Should the RBA retain the

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

Figure 1: Value of Credit and Charge Card Purchases ($m)

0

2000

4000

6000

8000

10000

12000

14000

16000

18000

Mar2007

Aug2006

Jan2006

Jun2005

Nov2004

Apr2004

Sep2003

Feb2003

Jul2002

Dec2001

May2001

Oct2000

Mar2000

Aug1999

Jan1999

Jun1998

Nov1997

Apr1997

Sep1996

Feb1996

Jul1995

Dec1994

May1994

Source: Reserve Bank of Australia.

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48

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

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.

ENDNOTES1 All data are available on the

Reserve Bank of Australia

Payments System website.

2 The RBA released an issues paper

for the 200708 review in May

2007.

3 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. 3236.

4 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 46,

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. 462472.

6 Richard Hayes 2007, An

Econometric Analysis of the

Impact of the RBAs 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

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.

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: [email protected]

Stephen King

Stephen King is a former MBS

professor and now a Commissioner

at the Australian Competition and

Consumer Commission.

Email: [email protected]

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.

gans king mr 2008

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