The Challenge of Bank Card Interchange

1. The Challenge of Bank Card Interchange Steve Mott Principal, BetterBuyDesign December 2005

2. The Burning Questions • Where are we now, and how did we get to this point? • What was the original rationale for interchange? • What’s the rationale now/how has that changed? • Does the new “value proposition” hold water? • What new issues are forced into the open by the emerging economics of interchange? • How are merchants and consumers reacting? • What are the resulting opportunities and challenges?

3. 1. Where are We Now? Attacks on bank card market power and interchange have been piling up since 2002 • Antitrust suits (allowing Amex et al to enter market) • Wal-Mart suit settlement • Merchant groups formed (Merchant Coalition, Merchant Payment Roundtable) • International challenges (Australia, EU, UK) • May 2005 Fed conferences (KC & Chicago) • Summer 2005 American Banker articles • 4 of the 6 rumored interchange lawsuits this year have been filed • Congressional Inquiry in wake of Katrina/gas price hikes

4. Banking’s Personality Challenges In many respects, these challenges play upon some inherent weaknesses • Banks tend to be terrible at communicating with one another • We’re worse at communicating to the outside world (e.g., “ID theft”) • We let the card networks do their talking for us • We don’t know our own costs • We don’t understand their own economics (e.g., direct mail solicitations, charge-offs, etc.) • We rarely price on value, so most products drop quickly to cost-plus pricing • We won’t talk about interchange

5. Now it’s “Winner-take-all” Consolidation On October 20, 14 interchange cases were consolidated by the same court (and judge, John Gleeson) which certified the Wal-Mart suit against Visa and MasterCard as a class action (Feb. 2002); 21 other “potentially related” suits would be treated as “tag-along actions)

6. Scene After the Wal-Mart Suit Settlement The Wal-Mart suit settlement was seen as a violent shock to the industry

7. Was the Court Satisfied with the Results? But the results were disappointing to many—big retailers got the benefits, but no structural change resulted

8. Guide to Some of the Key Lawsuits Four of the six big interchange lawsuits rumored for this year have been issued; these suits strike at the heart of interchange policies and practices

9. Anti-trust suit permitting banks to sell Amex & Discover products $3.2 billion settlement of “Wal-Mart” suit, rejecting the “honor-all-cards” dictum of the card associations Encouraged Visa/MC to raise interchange to “compete” with Amex rates Top 200 retailers got to negotiate discount rates, but smaller merchants got stuck with more increases Wheels of Justice Go Flat While these developments might bring cheer to some, for those who look for both fairer rates AND equanimity in marketplace, the courts have proved somewhat disappointing

10. Bad News from the U.K. Defense of signature card interchange is going badly in other parts of the world • INTERCHANGE FEES TAKE ANOTHER HIT: The United Kingdom's Office of Fair Trading, the government consumer protection agency, today issued a preliminary ruling against Visa's member banks, saying that the interchange fees banks charge to process transactions are anticompetitive. The OFT said Visa's multilateral interchange fee, which is applied to consumer credit cards, charge cards and unduly high fee being paid to card issuing banks by merchant acquirers on every Visa transaction deferred debit cards in the UK, leads to an "." The cost of these fees is being passed on to retailers and ultimately to consumers,” the OFT added. • In a statement, Colin Grannell, Visa UK's managing director, said the card association does not believe its interchange fees are unduly high. The preliminary finding wasn't unexpected in light of the OFT's preliminary ruling last month that interchange fees set by MasterCard's UK members were too high. Source: Cardline, 2005

11. The Specter of Australia Now, more than ever before, the specter of a fundamental change looms in the U.S. If it goes the way of Australia, change could be massive and consequences huge • RBA concluded that credit card usage was artificially high due to loyalty programs and interest-free credit—which were paid for by merchants • So interchange rates were halved (to .55%), with unexpected consequences: • Issuers shifted to Amex and Diners; charge-card growth surged • Consumers got hit with surcharges for credit-card use • Only a couple of new participants (Virgin Money, GE Money) appeared • Issuers lost $300 mil. in interchange, but profits went up 16% at ANZ, versus the 40% drop they feared • Merchants saved US$300 mil.; Australian CPI dropped 0.2% • RBA has now set its sights on setting debit cards at par (free), but large merchants—who receive interchange from issuers on some EFTPOS transactions—are fighting this new effort

12. 2. The Original Rationale Credit cards are widely acknowledged as the most successful consumer financial service product in the past half-century; the original rationale addressed important societal goals • Supported widespread, non-collateralized lending to qualified consumers • At efficiency levels better than merchants could provide (including lower cost of money) • With ability to use credit at any accepting merchant • And get instant gratification for purchases • Facilitated more efficient electronic purchases • Provided merchants with guaranteed payment • Provided end-to-end electronic processing • Moved consumers out of cash and checks • Reduced fraud and NSF risk

13. The Basics of Interchange The idea was to compensate transaction parties for the work they did Source: Diamond Cluster, 2005

14. Original Structure of Interchange Although little is publicly available about interchange, it is possible to piece together some cohesive theories on the original rationale and structure; the structural components had clear purposes: • Compensate issuers for costs of lending • Compensate acquirers for merchant vetting and processing tasks • Recover costs of network development and operation • Manage costs of fraud, given guarantees provided

15. Key Premise: Support Electronic Purchases With signature-based cards, consumers could afford to make a purchase right away, or make a bigger purchase than they otherwise would be able (or want) to make with cash or a check; the first merchant who accepted the card would stand to benefit from the resulting incremental sales opportunity by accepting the cards

16. Original Premise: Mission Accomplished So it’s easy to conclude that the original rationale for interchange has been fulfilled • 5 million accepting merchants • 65-75% of consumers with at least one card • Cards now produce a third of consumer purchases • Fraud is well-contained and efficiencies of electronic processing accrue to many

17. 3. What’s Changed But so much has changed since signature cards were introduced four decades ago—especially in the past 10 years; although the card networks have tried to morph these cards to fit all applications, there’s no doubt that they’re getting long in the tooth—along with many of their most loyal users • Market maturation • The shift to rewards to keep growth going • A force-fit for online commerce • Changing consumer behavior and merchant needs for different ways to pay

18. Maturing into a Convenience Play Consumer use of credit cards for lending has been flat for a decade, while spending continues to rise

19. Interchange More Important to Issuers Merchant-side business is now producing a better return than the cardholder side—naturally shifting emphasis to interchange

20. Credit Cards Leverage Rewards Bernstein Research estimates that 1% of interchange goes to financing cardholder rewards—which mostly go to affluent non-revolvers; Visa recently reported that 40% of cards would have rewards by next year

21. Primary Purpose of Cards Drives Use A large, but aging core group of credit card users regards rewards as their primary motivation for paying with cards; debit card users—a rapidly growing, younger group—want REAL pay-as-you go control

22. Characteristics of Changing Consumers New, emerging consumers are different than today’s transactors, and will be extremely receptive to debit account products that they can access from anywhere • The 18-34 age group is demonstrating a decided preference for debit payments over credit (Forrester, 2004) • 65% of college students have credit card debt; 50% charge them to the limit; but a Nellie Mae study in 2004 reported that outstanding balances had dropped 7% (from 2001) to a seven-year low of $2,169 per card, as students weaned themselves from this product • This demographic is highly-evolved toward Internet use (e.g., 60% are online bankers), and expect debit account access wherever they transact • 92% of high school graduates are Internet literate; Growing numbers are registering for new payment types (e.g. PayPal web site reports nearly 80 mil. accounts) • A new population “bubble” is moving through the marketplace with unprecedented willingness to shop their primary debit account to institutions who “get it” and offer the Internet and wireless services and access they demand

23. Components of Debit Migration Underlying the shift to electronic payments is a major migration to debit- account products, away from the heretofore credit-card centric consumer economy, to the tune of 40% of all payments by 2010 Shift to Debit Payments Sources: Nilson Report, Dove/ABA Study, BBD estimates

24. Debit Account Users: New Lifestyle Debit card users are growing in number, and have clearly different patterns for purchasing behavior—avoiding debt as much as possible

25. 4. New “Value-Proposition” The card networks have evolved their arguments for fostering signature card use and keeping interchange high to a new set of “value propositions” • High interchange fosters innovation • Providers are delivering new services, such as charge-back protections for consumers • Interchange pays for incentives to usage • There are costs for guarding against fraud • Payment guarantees can’t come free • Use of electronic processing provides valuable information • End-to-end service can be cost-free (once interchange is paid) • The number of merchants accepting continues to grow

26. Innovation Track Record? The bank card industry is not necessarily regarded as the seed-bed of innovation; but then again, a BAI research study in 2001/2002 determined that there were only three “disruptive innovations” in retail financial services in the past 40 years (monoline credit, mortgage brokers and credit-scoring)….

27. New Services: Charge-back Protection In the model of disruptive innovation, established market participants tend to add services that users don’t necessarily need in order to keep value (and prices) rising; in the case of zero liability and other charge-back protections, the industry has trained a generation of “free-riders” who routinely repudiate transactions—more or less at will—at exactly the moment that the industry needs to encourage more consumer responsibility and accountability for online security

28. Network Operations Costs Certainly, the costs of running the payment card networks has continually come down with the benefits of digital technology • Visa just finished a two-year upgrade of the Direct Exchange Network, which can do real-time authorizations for less than $.05 • Network costs through Private NetworkVPNIP evolution have reportedly dropped by more than one order-of-magnitude • Fraud costs are at an all-time low

29. Fraud is at an All-Time Low Card fraud in the banking systems continues to drop, and bank costs for risk management are stable; so this factor doesn’t drive interchange, either

30. High Cost of Sig-Card Risk Management Saddled with the liability for fraud, online merchants manually review 1 in five transactions, and block 4-5 good orders for every bad one—on top of fraud and charge-backs (especially “friendly” fraud); the situation for smaller merchants who can’t afford elaborate risk management systems is much worse Source: BBD Projections from RTD Business Model

31. Back-Shop Costs = 2 x Interchange The net result is that even the best and most competent online merchants are paying twice what they pay in interchange just to risk-manage anonymous signature card transactions Source: BBD Projections from RTD Business Model

32. Meanwhile, Charge-offs Have Soared In fact, true fraud pales in comparison to the industry’s somewhat self-destructive penchant for extending credit beyond the logical ability of incremental users to pay Source: Bank Technology News, March 2004

33. Merchant Vetting? And poorly-vetted merchants fuel charge-backs while generating high interchange

34. Competing Merchants Forced to Accept With so many merchants accepting cards in today’s environment, competitors are forced to join-in or risk missing sales ?

35. Result—Higher Cost of Doing Business The result is all merchants face a higher cost of doing business

36. 5. Economics Force the Issues Meanwhile, the economics of bank card usage are forcing serious examination of the underlying cost structure and pricing rationale • Interchange only goes up (unless you’re a national retailer with negotiating leverage) • But other digital processing businesses demonstrate the value to society of open competition • Signature cards are decidedly the most expensive way to transact in the merchant space • High interchange accrues mostly to the benefit of Issuers (not Acquirers) • Industry concentration has polarized relations/bifurcated strategies

37. Interchange Rates Trends For most merchants, interchange just keeps rising; for select merchants with negotiating power, some relief came in early 2004 Source: Visa, MasterCard, Corporate Reports and Bernstein estimates; BBD additions

38. Bank Card Interchange Rates Rising interchange has been a fact of life since the early 1990s; in a recent report, Morgan Stanley predicted an average rate of 1.85% by 2010 x Source: Nilson Report, May 2005

39. Telecommunications Counter-Example International calling prices dropped from $1.34 a minute in 1980 to $.21 in 2003, spurring a hefty increase in demand Source: FCC

40. Telecommunications Counter-Example Basic long distance services are experiencing normal declines in price expected for a maturing service [D]

41. Enormous Stakes for Merchants It takes unusual market power to keep interchange rates rising in a period of digital network efficiencies; for the world’s largest retailer the stakes are enormous—about $750 million in 2002 and more than a billion by 2007 that would otherwise drop to the bottom-line Source: Bernstein Research

42. Credit Cards Provide the Bulk of Fees It’s easy to see why the card industry is so protective of interchange; credit cards generate the vast bulk of merchant fees paid to FIs vis-a-vis all other payment types Sources: FMI, Paymentech, NDPS, Nilson Report, ATM/Debit News, PiperJaffray, BCG

43. Total Costs for Each Average Ring Factoring in all the transaction costs, signature cards remain the most expensive way to transact Sources: FMI, Paymentech, NDPS, Nilson Report, ATM/Debit News, PiperJaffray, BCG

44. Proportions of Each Ring Amount And when ring amounts are factored in, the signature debit card product emerges at even more expensive than credit cards Weighted Average= 1.29% Sources: FMI, Paymentech, NDPS, Nilson Report, ATM/Debit News, PiperJaffray, BCG

45. Bank Card Revenue—2002-2004 Looking at bank card revenue components from an industry level, interest remains the big driver—although merchant interchange is becoming more important Source: Credit Card Management

46. Card Revenue vs. Demographics Between 40-60% of revenue—mainly in the form of penalty interest rates and fees—is derived primarily by saturated marketing of cards to the next-to-lowest quintile—who can least afford them Penalty Fees Interchange Interest Non- Revolvers Paycheck- to-Pay- check (Don’t qualify for cards) Source: CCM, plus BBD projections

47. Bank Card Expenses/Margin—2002-2004 Meanwhile, charge-offs vastly eclipse fraud and other typical network costs; and the costs of cardholder rewards (part of “operations/marketing”) and billions of unproductive direct mail solicitations generate the bulk of industry costs Source: Credit Card Management

48. Card Costs vs. Demographics A substantial portion of marketing expenses now go to rewards, which mainly go to non-revolvers; charge-offs of debt mainly accrue to the next-to-lowest quintile, who now use credit cards for day-to-day living Non- Revolvers Paycheck- to-Pay- check (Don’t qualify for cards) Opns/Mktg Charge- offs Interest Source: CCM, plus BBD projections

49. Non-Revolvers Get a Free Ride? Non-revolvers tend to produce the lowest profits for Issuers, and are mainly relied upon to drive interchange revenue; but merchants don’t see benefits from serving these customers—particularly at premium-card interchange rates—since they can afford to pay by a variety of means

50. Industry Revenue/Income by Participant By far, the vast portion of industry revenue and profit accrues to the Issuers; in fact, acquirer margins have been regularly squeezed Sources: FMI, FirstData/Concord, EFT Report, PiperJaffray, BCG