First of two parts
Consumers are well aware of many payment system costs, such as annual fees for credit cards, check overdraft fees, late payment fees, and ATM fees. Far less obvious are "interchange fees" - which banks pay one another for each credit card, debit card, or ATM transaction made by their customers.
Interchange fees have risen rapidly in recent years, leading to increased controversy among merchants and banks. The debate over interchange fees is center stage in a class action filed by Wal-Mart and supported by almost every merchant in the United States, seeking more than $8 billion in damages for allegedly supracompetitive debit card fees.
Most people do not know that interchange fees are permitted under a narrow court ruling based on facts that are becoming outdated. Under antitrust law, competitors are rarely permitted to set prices collectively. Though interchange fees survived two antitrust challenges in the mid-1980s, many of the factual underpinnings for those decisions have changed substantially. It is time to reassess the role of interchange fees, their impact on competition, and whether they benefit consumers and are consistent with sound antitrust law and policy.
Interchange fees are set by credit card and ATM networks and are based on their internal, confidential assessments of cost. Typical credit card and debit card interchange fees are about 1.3% of the transaction amount and are paid by the merchant's bank to the card issuer's bank. In the United States, credit card interchange exceeds $10 billion a year, ATM interchange exceeds $5 billion, and debit card interchange exceeds $2 billion.
Though the costs of these payment systems have declined, MasterCard and Visa have imposed substantial increases in lockstep fashion over the past two years in reverse price wars that cost merchants and consumers hundreds of millions.
For example, off-line debit interchange fees rose more than 20% in the past two years. Why? The associations claimed "increased cost" and the need to foster "appropriate incentives for issuers and merchants." But the basis for these claims was cloaked in secrecy. Data communications and processing costs continue to plummet throughout the economy. Meanwhile, debit card volumes have been rising dramatically. One might logically expect costs per transaction to be falling. And industry observers said the profitability of off-line debit was skyrocketing. How were these price increases justified?
In a competitive market, consumers can turn to alternatives when faced with price increases. But in these markets, merchants effectively have very limited choice. As one merchant processor put it, "Because Visa and MasterCard have control of the market, they can do what they want and get away with it." Because merchants must accept off-line debit as a condition of accepting credit cards, a merchant's only alternative is to discontinue accepting all debit and credit cards - not a viable choice for most merchants.
Did consumers benefit from this reverse price war? Probably not. Consumers are concerned about cost, security, and speed. On-line debit, which runs through the regional ATM networks, is more secure and has a far lower rate of fraud (because a personal identification number is used) than off-line debit, and it is faster (because transactions are instantaneous). On-line debit costs less than one-quarter what off-line debit does. Though on-line is more efficient and secure, higher interchange fees led banks to prefer off-line debit. To secure higher off-line interchange fees, many banks have begun to charge consumers if they make on-line transactions. Because of this perverse competition, the less efficient payment system has prospered.
Price fixing by competitors is prohibited by antitrust law because, as the Supreme Court has said, price-setting is part of the "central nervous system" of the economy. Antitrust law, however, recognizes that collective price-setting can be permitted where "reasonably necessary" to the successful functioning of a joint venture. Interchange fees fall under this "reasonably necessary" exception. In an antitrust decision from the mid-1980s, Nabanco v. Visa, interchange fees were upheld, but that decision was heavily fact-based, and many of the factual and economic conditions underlying it have changed.
The mid-1980s are a bygone era in payment system terms. Credit card transactions were handled primarily on paper, and electronic networks were still largely on the drawing board. Both card issuance and merchant processing were very unconcentrated. Most important, both card issuance and merchant processing were done almost exclusively by banks, so the interchange fee was seen as simply a neutral transfer payment, not a potential profit center.
Nabanco, an independent merchant processor, had sued Visa, arguing that interchange fees were illegal price fixing. The court rejected the claim for several reasons, but each is severely weakened today.
Interchange fees are a means to recover costs. These fees are intended to compensate card-issuing banks for the risk of fraud and loss, the float, and the costs of card issuance. In the 1980s, various rules prevented card-issuing banks from recovering many of these costs directly from the cardholder.But these costs have been reduced radically in the past two decades as transactions have moved from paper to faster and safer electronic networks. Because of electronic transactions and authorizations, the card-issuing bank knows almost instantly whether a transaction is valid. Electronic processing has significantly reduced both the risk of loss and the float, and in any event far fewer regulatory barriers prevent card-issuing banks from recovering these costs directly from consumers. Thus, these costs are far less significant.
Interchange fees were set by a regulatory means and based on cost. The court felt a certain degree of security that the interchange fee was not anticompetitive because the level of the fee was based on a cost study by an independent accounting firm. This seemed to assure the fees' neutral nature.This quasi-regulatory, cost-based approach is practically unprecedented in antitrust jurisprudence. Antitrust courts and enforcement agencies rarely, if ever, accept promises that price-setting will be "cost-based" as a rationale for permitting competitors to set prices. There are several sound policy reasons for this. First, how can an antitrust court or regulator effectively regulate price-setting? Who would monitor price-setting? Which costs would be selected? Antitrust policy invariably prefers competition rather than collective price-setting based on a promise that the collectively set price is the "right" one.
Decades of unsuccessful government regulation have demonstrated that using cost as a basis for price-setting often creates the wrong incentives for the market. If price is based on cost, there may be less than optimal incentives for the venture or its members to try to reduce costs because they know that all their costs will be recovered.
Not surprisingly, as with any sort of "regulated" price, interchange fees have only risen. The fees may create incentives for starting and expanding a payment system network. Once the network of merchants or ATMs has been established, however, fees are effectively locked in; thus, there is relatively little incentive for the network to cut interchange fees, even in response to reduced costs. This problem is worsened when the network is effectively controlled by the card-issuing banks, which increasingly see interchange as an important source of revenue.
There was no less-restrictive alternative to interchange fees. The court found that no less-restrictive alternative to a collectively set interchange fee was available. At the time, card-issuing banks were prohibited from charging various fees to consumers, and this seemed to strengthen their argument for instead collecting fees from merchants.The court carefully considered whether interchange fees could be replaced by individual negotiations between merchants' banks and card-issuing banks but rejected the idea as impractical because Visa had 10,000 to 15,000 members and the transaction costs of negotiations between pairs of merchant and card-issuing banks would be prohibitive. Moreover, if some of these negotiations failed, a merchant might accept some Visa cards and not others - thus, the universal acceptance of the card would be diminished.
Finally, if there were no pre-established interchange fee, a merchant bank might face a problem of "hold up" by the card-issuing bank. Once the merchant accepted the transaction, it would face only a single card-issuing bank, which could charge whatever it wanted. Thus, a preset interchange fee prevented opportunistic behavior by the card-issuing banks.
These concerns are the strongest reasons for the continued validity of interchange fees. But do the costs of bilateral negotiations still hold up as a justification? Perhaps there are now more opportunities for this alternative. The credit card merchant processing and card issuing markets are far more concentrated that they were 20 years ago. Ten banks now issue more than 60% of bank credit cards, and one entity accounts for better than 35% of merchant processing. Though this doesn't suggest that transaction costs are trivial, they are far less substantial than formerly.
Unlike 20 years ago, banks have more ability to recover costs directly from consumers. As Alan Frankel, a noted economic expert, has observed, "If each financial institution party to the transaction can recover costs directly from customers, then exchange fees probably are not necessary at all for efficiency."
Perhaps the examples of the Internet and other payment systems suggest that many different types of firms can overcome these transaction cost problems without resorting to interchange fees. Even if bilateral negotiations were required for efficiency, there is no reason every bank would need to negotiate with each other bank. Rather, a logical alternative would be a system of correspondent banking relationships, with only a small fraction of banks actually connected directly to a significant number of other institutions.
Next: The impact of interchange fees on competition. Mr. Balto is director for policy in the bureau of competition of the Federal Trade Commission. This article presents his views, not those of the commission or any individual commissioner.