Published August 2013
Why change the current system?
In his proposal to regulate interchange fees Joaquin Almunia, the EU Financial Services Commissioner responsible for competition policy, said “in our investigations…we have found that these interchange fees which are collectively set by banks restrict competition and negatively affect retail prices”. The EU has proposed regulations which would cap interchange with the goal of increasing competition in the payments market. But what effect would changes to interchange have on banks and retailers? And will regulating interchange be good or bad for consumers?
These fees are worth a significant amount to banks. In the US where debit card interchange fees (or “swipe fees”) were recently regulated, debit card interchange fees alone were $16 billion in 2009, with the 10 largest banks collecting $8 billion1. Credit card interchange is normally even higher. In the UK it has been estimated that British banks that issue cards receive around $3.5 billion in interchange fees each year2. These are directly passed down to retailers and eventually onto the consumer; so regulating interchange has a tangible impact on the whole payments value chain. Given so much is at stake, you can expect continued strong lobbying from retailers and consumer interest groups to drive the cost of interchange down – and for Visa, MasterCard and banks to challenge these proposals.
What is interchange?
Interchange is the fee paid by the bank that acquires a transaction (“acquiring bank”) to the bank that issued the card on which the transaction is made (“issuing bank”). Every time a consumer uses a debit or credit card in a store to make a purchase the retailer’s bank pays an interchange fee to the customer’s bank. This fee is passed down to the retailer as the Merchant fee. These fees were introduced to distribute card processing costs and risks, as well as to incentivise banks to issue cards. These costs and risks include the systems infrastructure needed to send transactions reliably between retailers and banks, and the cost of fraud. Whereas merchant fees are negotiated between banks and retailers in a competitive market, interchange fees are generally set by the Card Associations (except in markets such as the US and Australia, where some fees are regulated).
Complicating the matter further – and attracting the interest of consumer advocacy groups and regulators – are customer surcharges that merchants sometimes impose on consumers if they choose to pay by card (in the UK, some airlines were famous for making more money on supplemental costs like this rather than on air tickets). Merchants will say the cost of card payments (the merchant fee) is significant to them – and to maintain margins must either tacitly increase the ticket price or explicitly impose a card transaction surcharge on the consumer. Regulation could therefore in theory benefit both retailers and customers.
Unintended consequences of regulation
However, regulation doesn’t always have the outcomes that policy-makers expect and Europe can look to other markets across the world that have moved more quickly than we have to understand the lessons learnt. So, what happened when Australia and the US regulated interchange fees?
Australia introduced regulation to reduce the interchange fees paid by the acquiring bank to the issuing bank on credit card transactions in 2003. Issuing banks were forced to reduce the interchange fees charged to their acquiring counterparts, who in turn passed this discount onto their merchants (through a reduction in the Merchant Fee). The Australian authorities had hoped at this point that retailers would continue to pass the cost saving onto their consumers; however the regulation did not result in lower pricing and was instead written to the bottom line of most retailers. And to make up for the estimated A$0.5 billion in lost interchange revenue, Australian banks increased card fees to their consumers, and reduced the value of their reward schemes. So far from reducing the cost incurred by consumers every time they used their cards, the regulation served to make payment more expensive as no cost saving was passed on to them from the retailers, but banks increased their fees. The unintended consequence of interchange fee regulation was that consumers were disadvantaged and felt pressure from both the bank and the retailer.
In the US most merchants benefited greatly from reduced fees when regulators imposed interchange fee caps on debit card transactions in 2011. However, merchants that processed small value transactions were worse off. Some of the fees paid by Banks are assessed on number of transactions rather than value, so there is little incentive for banks to encourage the micro payments smaller retailers rely on. Pre-regulation Visa and MasterCard offered discounts for small-value transactions, funded in part by interchange revenue, but these were removed post-regulation. A $5 transaction now costs merchants 21.25 cents, compared to 11.75 cents pre-regulation. Also, banks needed to make up their lost revenue, with a knock-on effect for many consumers: over 50% of debit card reward programmes ended in 20113, and monthly fees of non-interest checking accounts rose by 25%4.
At the end of the day, there is a battle for margin between retailers and banks – both will seek to maximise profits for their shareholders. Government regulators have the right intentions, but regulating a market that works can have all sorts of unintended consequences for consumers. In the UK, where consumers are used to “free banking” (a rarity reserved for the UK and very few other markets), it is possible that interchange fee regulation will not be a good thing – especially if retailers maintain their prices whilst banks increase or introduce card fees and reduce the value of reward schemes. Experience has shown that regulating a single section of a complex value chain only has positive impact on the end customer if every player can be trusted to pass on cost savings. Ultimately the effects are hard to predict, but the only certainty is that capping interchange can only ensure that banks will receive less revenue from retailers. In turn banks will attempt to replace any lost revenue with alternative revenue streams, whether through higher interest rates, penalty fees, or the introduction of per account fees as seen in Australia and elsewhere. It also possible that the regulation will allow new payment providers, such as mobile payment operators or PayPal, the opportunity to undercut and outmanoeuvre banks. Any regulation will have a major impact on the revenue models of card issuing banks and merchants –and we can expect the debate on interchange fee regulation to continue for some time.
- The Market Oracle, “Debit Card Interchange Fees and the Politics of Lobbying”, 1 June 2011
- The Economist, “Card Sharps”, 27 July 2013
- Pulse, 2012 Debit Issuer Study
- Bankrate Checking Account Survey, July-Aug 2012