Electronic payments in general and payment cards in particular are rapidly replacing cash and checks as the preferred means of making consumer as well as many business purchases. By enabling faster, more secure, traceable transactions, payment cards have been a key element in promoting greater integration of the world economy.
Indeed, the entire growth of e-commerce and Internet shopping would be inconceivable without modern payment card networks. However, the pace of future innovation and growth is likely to be hampered by increasingly invasive government regulation, especially regarding the fees that may be charged by payment card networks.
Both consumers and merchants benefit from the use of payment cards. Consumers benefit from convenience, such as by making transactions from home and avoiding holding cash. Meanwhile, credit cards enable consumers to make purchases even when they don’t have sufficient liquid resources – enabling them to smooth out their consumption.
Merchants also benefit in several ways. First, they make more sales because consumers are not constrained by the amount of money in their wallet (or the need to make a trip to the bank or cash machine).
Second, they enable businesses to process transactions more quickly (about twice as fast as cash – which in turn is faster than check). Third, the infrastructure required to support electronic payments is less cumbersome, piggybacks in part on existing communications networks, and reduces the need for physical security of currency (e.g., armoured cars and safes). Fourth, credit cards enable retailers to offload the cost and risk of offering their own credit operations.
This has enabled small businesses to flourish and grow, enabling them to compete with larger companies without the need to run their own, expensive credit operations. Fifth, payment card networks facilitate the collection and processing of enormously valuable consumer data that can be used by merchants to expand their sales. Finally, electronic payments enable long-distance transactions (over the Internet, for example), dramatically increasing the size of merchants’ available markets.
When all of these benefits to merchants are taken into account, payment cards are likely less costly for merchants than cash for a wide range of transactions. Indeed, when McDonald’s made the decision to accept payment cards, its stock value increased 2.7 per cent on the news, an indication that these benefits to merchants are substantial.
Greater use of cards has also reduced tax evasion and criminal conduct by overcoming the anonymity of cash that facilitates such activities. Meanwhile, in the modern era, the picture (and expense) of armed guards driving around pieces of paper in an armoured car appears more ridiculous with every passing day.
All of these benefits are made possible by banks and the payment card networks, which enable the transactions between merchants and consumers to occur. In “four party” schemes, issuers (most of whom are banks) provide payment services for consumers, acquirers (also mostly banks) provide clearance services for merchants, while payment networks (such as Visa or MasterCard) link together the issuing and acquiring banks through increasingly sophisticated and secure networks. In “three party” schemes, such as American Express and Diners Club, all the functions (issuer, acquirer, payment network) are vertically integrated.
Expansion of the use of these electronic payment systems has been brought about through considerable investment on the part of the banks and the payment card networks in hardware (cables, data centers, and so on) and software (including increasingly sophisticated “artificially intelligent” fraud detection), as well as ongoing expenditures on personnel to oversee detection of and manage potential and real fraud and theft. In addition, card issuers have expanded payment card sales through inducements such as reward point programs and cash rebates.
This investment – and the consequent expansion of use – has been funded by fees charged to merchants. In three party schemes, the fees are collected directly by the payment network operator. In four-party schemes, principally those operated by Visa and MasterCard, an “interchange fee” is collected by the payment network operator and passed through by the acquirer, who also charges a fee (merchants pay the combined fee – known as the merchant discount rate in the U.S. and merchant service charge in Europe – to the acquirer).
Over time, competition has driven innovation, which in addition to improving payments systems in general has also reduced costs. In the 1950s, Diners Club charged merchants a flat fee of 7 percent.
In the U.S., merchants now typically pay between 1 percent and 3 percent. Rates in other locations are similar but vary depending on factors such as the size and depth of the market, the type and size of the merchant, the average “ticket” amount (in some markets, lower fees are charged for small ticket items), and the extent of local fraud and theft.
In spite of the evident benefits to merchants and the innovations and cost reductions that have occurred over the past half century, larger merchants have pushed for the imposition of caps on fees. The result has been a spate of regulations capping fees for various types of payment card. An examination of four of these, in Australia, Spain, the U.S., and Canada provides insights into the consequences.
Australia introduced interchange fee caps in 2003. The adverse effect on consumers was immediate and substantial. First, annual fees on credit cards increased by 22 percent on standard cards and 47-77 percent on reward cards, costing consumers hundreds of millions of dollars in higher annual fees.
Second, Australian card issuers scaled back their rewards programs by almost 25 percent. Meanwhile, between 2003 and 2011, the amount of spending required for a cardholder to obtain rewards increased by 50 percent and the rewards to the cardholder as a proportion of spending fell from 0.81 percent to 0.54 percent. Third, investment in innovation by card issuers fell.
The fee caps also led to an increase in cash payments and the use of cards not subject to the caps, such as American Express’ three-party scheme, which increased its market share by 25 percent following price controls. Because American Express caters to high-income, high-spend consumers, wealthier consumers have been able to escape the higher costs and negative effects of interchange fee price controls, imposing the bulk of the costs on lower-income consumers.
Yet, after more than a decade of price controls in Australia, there is still no concrete evidence that merchant cost savings have been passed through to consumers, much less that any pass-through of savings to retail consumers has exceeded the increased costs and reduced quality to cardholders.
Spain instituted price controls interchange fees in 2005, cutting them on average by 57 percent. The experiment was terminated in 2010 due to the adverse effects, which included: increases in annual fees for consumers on credit and debit cards increased of approximately 50 percent (approximately 2.35 billion euros over a five-year period); reduced rewards and other benefits for consumers, and reduced innovation (except for security improvements required by law).
Moreover, as with Australia, there is no evidence that any of the merchants’ savings have been passed through to consumers in the form of lower prices or higher quality, much less that any pass-through exceeded the higher costs and reduced quality innovations suffered by cardholders. In addition, the higher fees for consumers slowed the adoption of payment cards in Spain and the displacement of cash usage by payment cards. (Although adoption of payment cards grew, this was driven largely by exogenous forces and, absent interchange fee regulation, would almost certainly have been more rapid.)
The U.S. introduced price controls on debit card interchange fees in 2011. The caps, which applied only to banks with assets over $10 billion in 2011, effectively halved the average interchange fee at such banks from $0.50 to $0.24 per transaction. Facing substantial losses, the affected banks raised other fees and reduced service quality.
Availability of free checking, for example, which was offered by 76 percent of banks in 2009 (up from 10 percent in 2001 due in large part to the switch to debit) fell to 39 percent in 2012. Among banks subject to the fee caps, free checking declined from 51 percent in 2011 to 27 percent in 2012.
By contrast, among banks not subject to the caps, access to free checking actually increased from 37 percent in 2011 to 44 percent in 2012. In addition, monthly maintenance fees were higher at banks subject to the caps than at those that were not. It seems difficult to avoid the conclusion that the caps caused the reduction in availability of free checking and increase in monthly maintenance fees among affected banks.
The knock-on effects of the fee caps have been substantial, with the costs falling disproportionately on the poor. Between 2009 and 2011, even as the economy rebounded and employment grew following the great recession, approximately one million Americans exited the banking system, presumably because they could no longer afford the monthly fees. That is a 10 percent rise in the number of unbanked.
Since people without bank accounts are unable to benefit from direct deposit, they must be paid in cash or with pre-paid debit cards. Unsurprisingly, there has been a dramatic increase in the use of pre-paid cards, which offer security advantages over cash (but, paradoxically, are not subject to Durbin’s restrictions). Meanwhile, the unbanked often resort to high-cost forms of lending, such as pawn shops and payday lenders to cover essential large-ticket items such as rent because they do not have access to lower cost loans such as pre-arranged overdrafts.
The main beneficiaries of the fee caps have been big box retailers, which have received a massive windfall in the form of lower interchange fees from debit transactions. Little if any of this has been passed on to consumers, however. It has been estimated that the net cost to consumers is on the order of $22 billion to $25 billion. Meanwhile, many smaller retailers are now paying higher fees because banks have eliminated small item discounts – putting these retailers at a competitive disadvantage.
Canada’s debit card system, Interac, has effectively operated as a government-mandated and regulated monopoly since 1996. Interac is permitted to recover only basic operating costs through a per-transaction “switch fee.” As a result, nearly all the costs of building and maintaining the debit card network are borne by banks and cardholders.
Contrast Interac in Canada with the United States before it imposed fee caps. In the U.S., an overwhelming majority of bank customers had free current accounts and unlimited debit card transactions, while in Canada, by contrast, an account with unlimited free debit card transactions carried annual fees of C$131-$167 and even accounts with monthly limits on debit card transactions carried annual fees of C$84-C$125. Meanwhile, Interac has lost market share to Visa- and MasterCard-branded cards that are less expensive and offer superior functionality to Interac-branded cards.
In spite of the negative effects of these regulatory interventions, and notwithstanding the Spanish government’s decision to scrap its price controls, the political popularity of interchange fee regulations continues to increase. In March of this year, the European Parliament passed a regulation that would cap interchange fees of debit cards at 0.2 percent and of credit cards at 0.3 percent.
The experience with interchange fee regulation in the Australia, Spain, Canada and the U.S. suggests that this will stifle innovation and undermine incentives to switch away from higher cost payment systems. It is likely to be particularly harmful in parts of the E.U. with low levels of card payments, such as Greece, Romania and Bulgaria.
If adopted, the E.U. interchange fee caps will likely prove even more harmful than the U.S. fee caps for several reasons. First, the U.S. caps apply only to debit cards, which have meant that covered banks have been able to incentivize consumers to switch to credit cards. Second, the U.S. caps apply only to banks with $10 billion or more in assets, which means customers at smaller banks have not experienced the full brunt of its ill effects.
Third, the Durbin Amendment provides at least some allowance for fraud prevention costs (albeit modest). By contrast, the E.U. fee caps will apply to a much larger proportion of payment cards, including all cards issued by all banks of any size, and provide no allowance to issuers for costs related to fraud prevention.
Where payment networks have been permitted to develop with minimal government intervention, competition has driven highly beneficial innovations, driving down costs and improving services for all merchants and all consumers. Where payment networks have been subject to price controls, innovation has been stymied, to the detriment of most merchants and most consumers. The planned introduction of such price controls in the E.U. is part of a worrying trend that is likely to reduce competition and retard innovation in payments.
At present, innovation continues apace in those large markets that are not subject to price controls. Some such innovations trickle through to regulated markets, though that is limited by the ability to recoup investments locally –as the experience of Canada clearly shows. But the more widespread such controls become, the more dramatic will be the impact on innovation.
Given the importance of payment networks to economic activity, such widespread price controls will be felt in reduced economic growth.