May 5, 2008

Has interchange regulation in Australia redistributed wealth in favour of merchants?

Mandated reductions in interchange fees in Australia were supposed to cause retail prices to drop, directly benefiting consumers. The whole idea is that interchange is a “hidden fee” that retailers bundle into their prices, and that a reduction in fees charged to merchants would benefit customers. Sounds like basic, logical thinking that you would find in a high school economics and civics class, doesn’t it? As it turns out, the regulatory experiment resembles a high school lab experiment gone wrong.

Here’s another report, this one by CRA INTERNATIONAL (summary, detailed report) that shows how mandated reductions in interchange fees have had the opposite effect of those that regulators were expecting. Retail prices are not lower. Instead, merchants enjoy stronger margins thanks to the lower cost of accepting cards. To make matters worse, banks have pretty much recovered their lost revenue by charging higher cardholder fees and cutting investments in payment innovation. Customers are the losers in this messy experiment.

Robert Stillman, Vice President of CRA INTERNATIONAL, writes, “We believe that the RBA’s intervention has redistributed wealth. There is no evidence that the undeniable losses to consumers from higher cardholder fees and reduced card benefits have been offset by reductions in retail prices or improvements in the quality of retail service. The RBA’s intervention has redistributed wealth in favour of merchants.”

The worse thing about this is that European Commission watchdog Neelie Kroes sees the Australian experiment as a success and wants to reproduce it in Europe. This makes me feel more and more that regulators are simply reacting to pressure from retail lobbyists, cloaking their decisions in some vague benefit to customers (and in Europe, some vague need to create a European payment scheme to compete with US brands Visa and MasterCard). I can’t for the life of me see why any regulator would possibly be doing this if they were not primarily interested in helping retailers improve their margins. What a mess.

At the same time, I can understand how merchants feel powerless as they see interchange fees imposed upon them with no ability to negotiate. “You don’t like our fees? Then stop accepting our cards.” That’s not the right answer. The irony is that a viable solution already exists in a growing number of countries. Leaving fees unregulated, but giving merchants the ability to easily surcharge card brands which are too expensive in relation to their value, creates a powerful incentive for schemes to make their products and services more useful to merchants. In response to this pressure, and to avoid having their cardholders subjected to surcharges, some payment brands will manage to create enough value to convince merchants to accept the higher fees, while others will simply have to reduce their fees. In practice, customers should see little if any surcharging, and merchants will get more value for their money.

This solution is echoed in a Wall Street Journal article by economist Leo Van Hove, titled “Regulating in the Dark”. Mr. Van Hove first tears apart the arguments for interchange regulation put forth by the European Commission, then offers the following conclusion:

“So if regulating one payment instrument can have unintended repercussions on substitutes, and a prohibition of interchange fees would be a leap in the dark, what are enlightened policy makers to do? They could simply try to ensure that market forces work, and in particular that merchants cannot be locked in by card networks. To that end, retailers should be allowed to ‘surcharge’ and pass on interchange fees to consumers. Promoting competition among card networks as well as among various payment instruments should also be high on regulators’ lists. More generally, we need policy makers who have a comprehensive vision of the future of our payment system – and who have the political courage to make cash more expensive in order to lower its cost to society.”

Here is a link to my prior post on why an unregulated interchange model is crucial to fostering competition between payment schemes, where I describe several ways in which payment schemes can innovate and create valuable new features and services for merchants.


Adam Levitin said...

Aneace, I think you should read the CRAI study more critically. For starters, it might be good to note that CRAI's research has been funded by MasterCard Worldwide. In my book that makes it largely worthless. But then it's very hard to find anyone who studies credit card issues who isn't on the card industry's payroll.

Then to the heart of the CRAI's claim--that there is no evidence of a consumer welfare benefit to the RBA reforms. This is really a question of burden of proof. Should the RBA have to demonstrate consumer welfare increase or should the card industry have to demonstrate lack thereof. As an evidentiary matter both positions are virtually impossible to prove. Whether the savings from lower interchange are passed on to consumers varies by merchant and cannot be isolated out from the other myriad factors affecting price. As a matter of economic theory, we'd expect some consumer benefit and some of the benefit to be retained by the merchants. CRAI has a model of consumer benefit, but it depends on a large number of debatable assumptions.

And CRAI takes a very narrow view of consumer welfare. I would argue that it should include (1) benefit to revolvers in the form of greater competition for their business when interchange revenue declines, (2) societal benefit from decreased credit card use for pure transacting, both because of the higher costs of the payment medium and because of the percentage of folks who fall into interest and fee quagmires and cease to be economically productive.

Adam Levitin said...

Also, Aneace, is unregulated interchange mean interchange unaffected by government regulation or interchange unaffected by any regulation, including network rules like no-surcharge and honor-all-cards? I think it is important to see that card network rules are as much an interference in the free market as the same rules would be if imposed by a regulator.

Aneace Haddad said...

Hi Adam. Always good to hear from you. I can understand the need to make it easier for merchants to surcharge certain card products, so I would agree with your comment on network rules. Many countries have already done away with no-surcharge rules, so the solution already exists. What I seriously question is the ability or relevance for regulators to fix interchange fees at specific levels as they have done in Australia. That's overkill. And it doesn't respect the need to create more competition between schemes.

ForumRead said...

Not necessarily, merchants are NOT forced to take credit cards, many due so to increase business, get payment more securely and quicker, and pay a fee to the issuer in return for a service, it also reduces tax evasion.

Your argument about surcharges is a bit incorrect, its a contractual relationship , its just like a franchise, or a retailer selling Sony products for a minimum advertised price.

In this it is no free market, now of course the card companies abuse things and there is necessary regulation to prevent massive late payment bills and tricks such as holiday due dates.

Neither the banks or the retailers really care about consumer welfare, but consumers will generally suffer, since merchants will not pass on the savings and the banks may not only increase credit fees, but also bank and checking account fees, of course the banks' have their only profit motivations which are not aligned with the consumer's interest (for example tricks they use).

That is the problem with people always asking the government for favors.

There is an issue with monopolistic behavior, but the broader picture really isn't being discussed here.