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Australia has engaged in a unique experiment in he number of credit and
charge card accounts in
credit card reform, which has included capping Australia has increased by
and cutting the interchange fee. Our experience around 5 per cent in the past year to
almost 14 million. About $17 billion
from this reform indicates that the RBA can worth of transactions per month
now safely avoid the costs of ongoing regulatory involve credit or charge cards, with
debit cards accounting for around
intervention by setting the interchange fee at a
another $7 billion in monthly
desired level and leaving the market to itself. purchases.1
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the melbourne review Vol 4the melbourne
Number 1 May 2008review
Since 2002 the Reserve Bank of services the merchant (the acquirer). The RBA’s primary concern related to
Australia (RBA) has imposed a Payments move between these the interchange fee that was charged
variety of regulatory reforms on the parties when the customer uses the between the issuing and acquiring
card systems. These include capping card to make a purchase. banks. It argued that these fees for
the ‘interchange fee’ that is payable credit card transactions were too high
The customer pays the merchant for and were not subject to competitive
on debit and credit cards, opening
what they buy, while, for a credit forces. While the RBA recognised
up access to the card schemes and
card transaction, the merchant pays that restrictions on surcharges for
the EFTPOS system, and banning
a service fee to the acquirer. The card transactions could also limit
certain rules that previously applied
acquirer pays an interchange fee to competition between payment
to merchants who accepted cards,
the issuer. The customer may also instruments, and required their
such as the no-surcharge rule and the
pay the issuer for the card, or be paid removal, it did not think that this
honour-all-cards rule.
by the issuer, for example, through fully addressed the interchange fee
These reforms have been significant.
For example, before the RBA
intervened, the average interchange
The RBA’s primary concern related to the interchange
fee on credit card transactions
was around 0.95 per cent. This is
fee that was charged between the issuing and
currently capped at 0.50 per cent acquiring banks. It argued that these fees for credit
— nearly half the pre-reform level. card transactions were too high and were not subject to
The reforms to credit cards have been competitive forces.
strongly supported by merchants,
who bear the direct impact of the
interchange fee, and strongly opposed loyalty points based on the value of problem. As a result, the RBA capped
by the banks and card schemes. the transaction. Traditionally, the the interchange fee.
merchant has been subject to a no-
The RBA is currently reviewing There are good economic reasons
surcharge rule imposed by the card
these regulations to determine their why the interchange fee that is set
scheme, meaning that the merchant
effect and to consider whether or in the market may not be at the
had to offer the same price to a card
not they should continue.2 In this socially optimal level. Card systems
customer as it offered to a cash
article we briefly summarise the represent what economists call
customer despite facing different
economic principles underpinning ‘two-sided’ markets. In a normal
costs and benefits with these different
card regulations. For simplicity, we one-sided market a customer simply
payment instruments.
focus on so-called ‘four party’ credit approaches a retailer who sells the
card systems although similar issues good they desire to purchase. The
apply to debit cards. We consider the retailer will have purchased the good
effects of the regulations imposed from a wholesaler, who, in turn,
by the RBA and how they might be would have purchased the good from
modified in future. an upstream supplier, and so on back
to the manufacturer. There is a linear
What is the problem? chain of transactions that turns the
Card systems generally involve four basic inputs into a product delivered
to the customer.
parties: a customer or card holder, a
merchant who is selling something Two-sided markets involve
to the customer and who is willing to transactions that are moderated
accept the card as payment, the bank through central organisations
that issues the card to the customer and provide benefits to a variety
(the issuer), and the bank that of customers simultaneously. For
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the melbourne review Vol 4 Number 1 May 2008
example, a media company brings choice of payment instrument has interchange fee allows the ‘net
together viewers or readers and implications for the merchant. If external benefit’ from the choice of a
advertisers. The advertisers pay payment instrument A is cheaper payment instrument to be transferred
the media company to show their from the merchant’s perspective than to the customer. The customer
advertisements but this payment payment instrument B, then the will then face the socially optimal
usually depends on the number of merchant would prefer the customer incentive when choosing a payment
viewers. The viewers buy a product to choose A rather than B. In the instrument.
from the media company, not for the absence of either a price differential
advertisements in general, but for on the final product that depends on 2. Under a no-surcharge rule, there is no
other content. But they are exposed the choice of payment instrument
reason to expect that the market will set the
to the advertising as part of their (i.e. a surcharge) or an interchange
optimal interchange fee.
viewing. So the media company fee, the customer will simply choose A variety of factors comes into play
moderates a two-sided interaction a payment instrument according to when banks set the interchange
between viewers and advertisers and fee for a card system. If the fee
their own costs and benefits.
sets prices that seek to balance the is set too high, this will raise the
interests of these two groups.3 The externality created by the merchant services fee and discourage
customer through their choice merchants from accepting the card.
A credit card similarly requires
of payment instrument can be If the interchange fee is set too low,
coordination between card holders
internalised either by a surcharge then the issuer bank may have
and merchants. A credit card is of
or through the interchange fee. In little incentive to promote the card
little use to a customer if it is not
the absence of surcharging, the to customers and customers will
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.
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the melbourne review Vol 4the melbourne
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have little incentive to use the card. 3. If there is perfect surcharging, the merchants. But this does not imply
Competition among both issuers and interchange fee is irrelevant. that regulation of the interchange fee
acquirers can affect the interchange is the solution.
If merchants impose a surcharge
fee, as can the existence of competing
on the basis of the specific payment The obvious implication is that,
payment instruments. However, even
instrument used by a customer, the to the extent that the level of
if there are a number of strongly
actual interchange fee is irrelevant. the interchange fee is a concern
competing card systems, the market The merchant simply passes the for regulators, removing the no-
need not establish the economically costs of the payment instrument surcharge rule should help to
optimal interchange fee. on to the customer through the overcome this problem. The RBA
This result is unsurprising. After all, surcharge so that a rise in merchant agrees with this but also believes that
we do not expect other markets where fees (possibly due to a rise in the the removal of the no-surcharge rule
externalities exist to automatically
reach an optimal price, regardless The economic principles underpinning credit card
of the degree of competition. For
markets suggest that there is likely to be an economic
example, if there is a negative
externality like pollution, we expect
problem with interchange fees for credit cards when
a competitive market to set the price there is also a no-surcharge rule on merchants. But this
for the relevant end product at a level does not imply that regulation of the interchange fee is
that is too low (i.e. which does not the solution.
take into account these costs). That is
one of the reasons why governments
interchange fee) is simply reflected by itself will not fix the interchange
intervene in markets where there are
in a higher surcharge. The reason for fee problem. As Philip Lowe,
strong externalities.
this is simple. If merchants impose Assistant Governor of the RBA,
The externality created by the ‘choice a surcharge, there is essentially a noted:
of payment instrument’ means that redundant price involved with the use In thinking about appropriate
even competitive cards markets are of a payment instrument. Any change regulatory responses to these
unlikely to set optimal prices. Both in the interchange fee can simply distorted price signals, the RBA
the degree of market failure and its be ‘undone’ by changes in the mix considered simply requiring
direction can depend on a variety of of the surcharge, the merchant fees, that the no-surcharge rule
factors. For example, multi-homing and the customer card fees. While be removed, thus allowing
— where customers tend to carry a surcharging makes the interchange merchants to charge customers
variety of cards and merchants can fee irrelevant, even with perfect using a credit card a higher price.
limit the range of cards they accept surcharging there may be a ‘problem’ … We saw considerable merit in
without fear of losing many sales of pricing for payment instruments. this approach, and have in fact
— can help markets to set prices that However, this problem cannot be required that the no-surcharge
more accurately reflect true costs. In rule be removed from merchant
addressed through regulation of the
this situation, merchants can at least contracts. However, our view has
interchange fee.
partially reflect the costs that they been that removing this rule was
face through the choice of payment Is regulation the solution? not enough, by itself, to establish
instrument by not accepting cards more appropriate price signals to
The economic principles
cardholders.4
that are ‘too costly’. This helps offset underpinning credit card markets
the externality. But the general suggest that there is likely to be an The regulatory problem, however,
result still holds — the market is economic problem with interchange is that any explicit regulation of
unlikely to set the ‘right’ fees for credit cards when there the interchange fee will either be
interchange fee. is also a no-surcharge rule on uncertain or useless. If the removal of
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the melbourne review Vol 4 Number 1 May 2008
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the melbourne review Vol 4the melbourne
Number 1 May 2008review
Figure 1: Value of Credit and Charge Card Purchases ($m) paper, the RBA canvasses
the possibility of setting all
interchange fees to zero.
18000 18000
• Does the lack of effect mean that
16000 16000
the RBA should remove the price
14000 14000
cap? Unfortunately, perhaps,
12000 history matters and there 12000
is
10000 no guarantee that removing 10000
the existing interchange fee
8000 8000
regulation will return the market
6000 6000
to the relatively benign stable
4000 4000
interchange fee that previously
2000 existed in Australia. 2000
Mar–2007
Jul–2002
May–1994
Apr–1997
Mar–2000
Feb–2003
Jan–2006
Aug–2006
Dec–1994
Nov–1997
Oct–2000
Jun–1998
Nov–2004
Jan–1999
Sep–1996
Aug–1999
Jun–2005
Sep–2003
Apr–2004
Feb–1996
Jul–1995
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the melbourne review Vol 4 Number 1 May 2008
us to conclude that the RBA can way that favours their particular
safely avoid the costs of ongoing interests. At the aggregate level
regulatory intervention by setting the the reforms may have had little
interchange fee, once and for all, at a effect but there may still be
desired level and otherwise leaving transfers associated with the
the market to itself. ■ regulations.
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