Understanding I nterchange F ees

Understanding Interchange Fees Jean-Charles ROCHET Toulouse School of Economics Prepared for the conference "The Economics of Payment Systems" ENST, Paris, October 25-26th, 2007

1- INTRODUCTION • Interchange Fees (IFs) have lately received a lot of attention from • Regulators, 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...

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

Introduction 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)

My objective here: • to try and summarize in a non-technical fashion the points • of 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

2- DOCTRINES 2.1- Cards Systems / Banking Associations Viewpoint • “DOCTRINES” ARE PRESENTED IN ITALICS (please do not cite me on these statements) • Open card systems are joint ventures set up by banks (issuers and acquirers) • “IFs are interbank transfers that allow banks to share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 these • joint ventures in a fair and efficient way”. • Two considerations: • "fairness": equalize costs/and or profits • "efficiency": maximize "value" of system.

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. Cost elements included in the IFs

Doctrines 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 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 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) .

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?

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.

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 2003 in the USA) IFs decreased for off line debit and increased for on line (PIN) debit.

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].

Facts 3.5- Evidence on Multi-Homing • Rysman (2007), exploiting Visa PSPS data set on US consumers • has 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)

4- ECONOMIC ANALYSIS 4.1- Usage Externality (Baxter) • When a consumer pays by card instead of cash he inflicts • three 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)

Economic Analysis Social welfare is maximum when the consumer fee is equal to this total externality Total user surplus (buyer + seller) is maximum when the externality to the merchant is nil (Farrell's indifference criterion).

Economic Analysis If acquirers are perfectly competitive, the IF that maximizes Total User Surplus is (Baxter) cost of cash for the seller cost of card for the acquirer The IF that maximizes social welfare is higher, since it includes issuers' margin issuer margin

Economic Analysis 4.2- Social Welfare VS User Surplus • Competition Authorities often care only about user surplus and • not 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 is • in between and

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)

Economic Analysis By contrast, if most cardholders have several cards, it is less costly for merchants to reject one of them  low IFs. (close to Total User Surplus maximum ) W (Social Welfare) TUS (Total User Surplus) Competitive IF is in between (complete multi-homing) and (monopoly or competitive bottleneck) [open question] US enigma: competition for issuers  increase in IFs

Economic Analysis Intra-system competition drives down banks‘ margins and therefore total user price The impact on IFs is less clear Banks’ margin independent of issuer margin Quality of Service (increases when issuer margin decreases)

Economic Analysis 4.4- Debit VS Credit So far, theory has paid too little attention to the substitutability between credit and debit. Recent empirical work: Zinman (2007), Ching and Hayashi (2007), Bounie, François and Kiser (2007) indicate that consumers payment 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 to encourage credit use.

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

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.

Understanding I nterchange F ees