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Weep Not for Interchange Fee Revenue

This article was written by in Banking. 33 comments.


I used to answer customer service calls for Bank of America, one of the nation’s biggest banks. Granted, I was near the bottom of the totem pole, but they generally treated everybody with respect there (I was in Washington State, your mileage may vary), and they wanted us to be able to give customers informed and detailed answers.

During the first week of training, we were taught the core of how a bank stays in business: lend people money and charge them interest on the loan payments. I, and probably you, spend a lot more time thinking about the bank as the safe place where we keep our money and who puts their logo on our debit cards and whose ATMs don’t charge us fees. However, those are just convenient services the bank offers in order to have the money that they can lend to other people, and get a return on their investments. They offer these services for free most of the time, not only because all the other banks are doing it, but also because there are now multiple generations of Americans who are accustomed to free checking.

Most importantly, though, they offer these services for free because they can afford to, and because they need your money to loan to others. They’re not primarily in the business of processing checks and debit card transactions, they’re in the business of loan payments.

I know that banks offer dozens more services, and that operating a global corporation is complicated, to put it mildly, but since the beginning of banks, the description above has basically been the business model. If all foreign exchange, credit cards, investment accounts, home equity, and retirement services disappeared tomorrow, banks would still be in business, and still earning plenty.

But they want you to believe that the lowering of interchange fees — the money the bank makes when you use your debit card at a store — is going to force them to raise fees on other services, and that otherwise they’d go out of business.

That can’t be true. For example, in the second quarter of 2010, Bank of America earned $29.5 billion in total revenue, and they earned about $2 billion on “card income” (source). $2 billion is a large amount of money, but the card revenue represents about 7% (I’m rounding up) of the amount they earned in total. A 7% loss is about half of what you might tip a waiter, though for me it’s more like one-third of what I tip a waiter. (Note: this paragraph used to have incorrect numbers, hence the confusion in the comments below.)

Many banks are complaining through news outlets that new, future regulations regarding interchange fees will unfairly hurt their profits, and that they’ll be forced to discontinue free checking services and raise fees on other services. (See our earlier reporting on the changes to these swipe fees.)

Compared to the rest of the world, American interchange fees are exorbitant and unnecessary. They make it impossible for the corner store to make a profit when they sell you a banana and some coffee. Lowering them to something “reasonable and proportional” won’t hurt the bank’s ability to earn revenue. I admit that it might decrease their bottom line, but their bottom line has been inflated by ridiculously high interchange fees for years. Why not accept that they’ve been gouging their merchant customers and move on? It’s not as if the government is asking them to return any of this currently inflated income.

Amazingly, Citigroup’s CEO is doing just that. Last Friday he said he isn’t worried about his company’s ability to deal with lower revenue from reduced fees, even though they made about $152 million from those fees last year. So it is possible to adapt, and continue to offer free checking, and not raise other fees. At least one household-name bank is willing to play along, and I hope the other banks follow suit.

Pandit Says Citigroup Can Absorb Curbs on Fees, Cyrus Sanati, New York Times, July 16, 2010
Banks Seek to Keep Profits as New Oversight Rules Loom, Eric Dash & Nelson D. Schwartz, New York Times, July 15, 2010
Bank of America Second Quarter 2010 Earnings Presentation, bankofamerica.com

Updated July 26, 2010 and originally published July 23, 2010. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Smithee formerly lived primarily on credit cards and the good will of his friends. He is a newbie to personal finance but quickly learning from his past mistakes. You can follow him on Twitter, where his user name is @SmitheeConsumer. View all articles by .

{ 33 comments… read them below or add one }

avatar Wojo

I’m interested to see how this will affect “rewards” cards, which from what it seems like, are funded by these interchange fees and other fees that will be curbed. Then again, I guess I’d rather keep my money up front rather than get it back in rewards later.

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avatar Steve

Me too. This is true even if my “share” of rewards ends up distributed amongst all of society.

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avatar Apex

reward cards should not exist. The fact that they do exist is evidence in and of itself that there is an inefficiency in the system, whereby banks are receiving payments (fees) that drastically exceed their costs of doing business and competition has caused them to refund a portion of that back to the card holders to compete for their business (read bribe them into using their card – it’s the same game as the auto glass companies who were found to be giving away free steaks with windshield replacements by overcharging insurance companies and then bribing consumers to use their company with a portion of the overcharge. It’s nearly an exact parallel to this situation with credit cards)

So how does that look? Something like this. (These are made up numbers but the first one is a guess which I suspect is actually too high and the others are pretty close to reality)

1. Actual bank costs to perform an electronic transaction and cover all costs and overhead and money related expenses equals 0.5%
2. Money banks receive in fees for performing a transaction equals 2% which is taken from the merchants which means over time merchant prices have to eventually rise to cover the full cost of that 2%.
3. Average cash back given on most cards is around 1%

4. Bank still has almost 0.5% profit on fees alone after giving the reward.

I suspect an interchange fee below 1% and as close to 0.5% as possible is more than enough to fund the system.

So rather than charge me 2% more and give me 1% back I would prefer you charge me 0.5% more and give me nothing back. I didn’t need to pass calculus to determine which one was better.

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avatar jim

“For example, in the second quarter of 2010, Bank of America earned $719 billion in net interest income from “average loans (excluding mortgages),”

I’m sure that $719 billion figure is a mistake. BoA’s total annual revenue is around $150B. theres no way they could make $719B in interest in a quarter. Maybe it is supposed to be 7.19 B or 719 million ?

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avatar Smithee ♦1,358 (Quarter)

I was surprised at that number, too. But if you want to look at the data that I looked at, maybe you could help me find my error:

http://investor.bankofamerica.com/phoenix.zhtml?c=71595&p=irol-irhome

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avatar J

On page 10 of the main presentation, it says net interest income for 2Q10 was $13.2 billion, but that’s for the the entire bank’s operations — mortgages, trading, etc. You have to look at different lines of business separately. It would be completely unfair to someone with a Bank of America mortgage for the bank to say, “Well, we can’t earn interchange fees from our checking account customers anymore, so we’re going to keep your interest rate a little higher than it otherwise would be so we have money to give away free checking to everyone!” The bank will not do that. Each product has to cover its own expenses and provide a reasonable return on capital. Just because they make lots of money on mortgages (which has to cover all the various expenses associated with servicing mortgages, by the way!) doesn’t mean they can just give away free checking accounts with no source of revenue to pay for the expense of providing checking accounts.

If you look at just checking accounts, there does not appear to be any interest income on checking accounts with debit cards. Presumably some portion of the services charges — $2.6 billion in 2Q10 — are for those accounts. These other things are other lines of business. Their total profit was $3.1 billion. You better believe that they will care about the loss of $2 billion. Bank regulators actually require banks to be fairly profitable in order to reduce the risk that the bank will fail and have to draw on FDIC support, so even the government would not be OK with them just letting their net income drop by 66%.

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avatar Smithee ♦1,358 (Quarter)

The number I found was on page 14 for “Average Loans”. I did what I thought was sufficient research to find the definition of “Net Interest Income”, but maybe they’re using that term in a different way?

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avatar jim

Page 14 lists the amount of the loans, not the interest paid. So they have $713B in total loans. Page 14 is a continuation of the section on net interest started on page 13. Page 14 is just showing details on the totals of the amount of debt owned by BoA. The interest paid is shown in the figure on page 13. Like J said, the interest paid is $13.2B.

avatar jim

Lets look at it another way. $713B in a quarter is $2.85 Trillion on an annual basis. The US government had receipts of about $2.1 Trillion in 2009. One bank doesn’t make more in interest on non-mortgage loans than the entire federal government takes in in receipts, not even close.

avatar Matthew

You should consider posting a correction to this. If you’re going to use the $2billion number on page 10, the logical reference would be to the total income on that page $29.45billion. The number on page 14 is an amount of loans outstanding and clearly not an income number. It should be obvious that Bank of America is not making almost a trillion dollars in interest income in a quarter. ExxonMobil, usually the most profitable company, has been making around $10billion a quarter in earnings.

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avatar Smithee ♦1,358 (Quarter)

I will be posting a correction shortly, but I’m taking it on faith that the corrections I’ve gotten are correct.

“The number on page 14 is an amount of loans outstanding and clearly not an income number.”

I wouldn’t say “clearly”. The page title says “Net Interest Income” and then it goes straight to “Average Loans”. If they were referring to outstanding values, or amounts or balances or properties, I would expect to see some combination of those words used. They just use “Interest” and “Loans”.

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avatar J

I think the complaints about interchange fees are fairly silly. First and most importantly, the banks don’t force merchants to accept the cards. The merchants accept them because it’s more convenient for their customers and for the merchant, and that added convenience outweighs the fee that the bank charges. Merchants are free to encourage their customers to use alternative forms of payment, and they legally can offer cash discounts (or their own rewards program for customers who use a preferred means of payment the merchant offers).

Also, while it’s true that merchant agreements technically prohibit merchants from imposing a minimum charge, in practice Visa/Mastercard do not enforce that prohibition except against large, nationwide merchants. Your corner store can say they won’t let you pay for banana and coffee with your credit card and instead say you have to buy at least $5 or $10. There are some small merchants that do this, and as a practical matter, Visa/MasterCard do not do a damn thing about it. They used to accept complaints about merchant minimums on their Web site but in recent years they stopped offering that option and no longer actively enforce the rule, except against large merchants.

Economists have found that credit and debit cards confer numerous positive “externalities” on society. That is, people other than the merchant and the consumer are better off when more people use cards to complete their transactions. Why? Widespread credit card use has resulted in a substantial reduction in robberies and related crime (credit card fraud is much less violent and dangerous); it improves tax compliance so people in what would otherwise be “cash businesses” don’t gain an unfair tax preference by underreporting their income; and it has made life vastly more difficult for crime organizations that attempt to launder money.

As for the rewards programs being an indicator of inefficiency, I think the complete opposite is true. When the merchant pays that 1.9% fee to Visa/MasterCard (fees are actually lower on average for physical stores that process mostly in-person transactions, but let’s use 1.9% for now), 1% — more than half of the fee — typically goes back to the consumer, either in the form of a cash back or other rewards program or a lower interest rate or checking account fee than they would otherwise pay to the bank. The rest of it covers fraud losses, overhead at Visa/MasterCard and the banks, etc. The rewards program encourage consumers to use credit/debit cards, resulting in the positive externalities mentioned above.

Moreover, countries that have capped interchange fees have generally seen poor results. In Australia, for instance, interchange fees were lowered by government fiat, and the result was *not* an increase in efficiency or benefits to consumers. Instead, banks — which actually have very low profit margins on credit/debit accounts, by virtue of operating in an extremely competitive market where they give lots of things away for free — had to raise annual and other fees to make up for the lost revenue. There was absolutely *no* evidence whatsoever that prices were lower at merchants following the change. Many merchants actually effectively increased prices following the change, adding 3% surcharges for credit/debit card use that vastly exceeded the actual cost to the merchant of accepting those cards.

In general, I think the economics of card payments are too complicated for most consumers to understand, so they incorrectly think that the fee is just some big profit that the bank keeps. In fact, there are lots of reasons why the current level of “fees” are efficient and why we should encourage consumers to make more use of electronic payment methods like credit and debit cards. The reasons the merchants push for the fee reductions is that they’re the ones who stand to gain the most if the fees are reduced — consumers are the ones who will lose out by virtue of the change.

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avatar FactChecker

Well said, in fact in Australia companies are charging much more than the interchange fee itself, how can they get away with that because they know consumers often have no choice to pay since they are traveling in hotels, taxis, etc and may not have a lot of cash. Australia cards also charge interest from day one, and the writer ignores that cash itself is not free unless you are a tax evader, it costs money to handle, account, hire security guards, there is an issue of counterfeit money, and inside theft.

Furthermore, a credit card enables a consumer to dispute a transaction, offers warranty and other protections, and is a safety net for many consumers who not only may not have lots of cash on them but also in terms of purchasing items on credit rather than debit which can be subject to fraud.

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avatar Eddie

It will just become an excuse to jack up fees everywhere else. I use a bank and a credit union- both sent out requests to contact our representatives and oppose the Durbin Amendment. And when I say “requests”, I mean “thinly veiled threats that passage of this Act will quickly lead to the death of free checking, increased credit card fees, and the general implication that if they can’t get my money one way, they’ll get it another.”

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avatar Andy

This is just another of the many laws inacted to placate the majority of a very ignorant population. If people cared more about their finances and how to protect themselves instead of which celebrity is going to jail this week, we wouldn’t need a Congress full of financially challenged lawyers making laws that are only going to hurt the poor and middle class in the long run.

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avatar Smithee ♦1,358 (Quarter)

It’s always interesting to me when people take the time to defend a company’s right to charge whatever they want for a service, regardless of how much it costs the company to perform that service, and regardless of a barren competitive landscape, ensuring that company’s ability to keep charging the inflated prices, because “market forces” will never push it down.

But I suppose that’s why we get together and vote every few years.

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avatar J

I disagree that payment cards are not competitive. It is actually one of the most cutthroat competitive businesses out there from the consumers’ perspective, and profit margins on a per account basis are quite small. Many businesses — take your corner coffee store, as an example mentioned earlier — enjoy a small local monopoly because it’s impractical for their consumers to go elsewhere to get the service. If you live at the corner of 9th Avenue and 43rd Street, you’re not about to trek all the way to 3rd Avenue and 14th Street just to get a cup of coffee in the morning. The marketplace is effectively limited by who’s nearby to you.

That’s not true for payment cards. There are literally several hundred, if not thousands, of banks and credit unions in the United States that offer credit and debit cards, and the way that most consumers use credit cards, at least, they do not require branch services. (I know that some consumers like to have a bank branch nearby them for their actual checking account and debit card, but even for that, many consumers have happily transitioned to online accounts and are just as happy so the online-only banks are a competitive threat regular banks have to take seriously.) There are probably at least ten big banks that compete with each other very aggressively for credit card business — but if you don’t like the big banks, you are completely free to take your business to one of the many large credit unions like Pen Fed and USAA that offer cards, or even a small bank or credit union in your area. All of these banks set prices and rewards programs for consumers independently, and they all compete aggressively for banking business. From the consumer standpoint, it’s also basically costless to switch. If some new bank comes along and offers a much better offer, they can steal another bank’s customers in a heartbeat, because all it takes a creditworthy consumer is a simple one-page application for you to get a new card. Most other businesses that you use on a daily basis do not experience anything close to that level of competition, with literally hundreds of other competitors who can provide the exact same service and no cost to the consumer to switch. I do not believe that the Antitrust Division or even any respected economist has suggested that the U.S. banking industry is noncompetitive. Quite the contrary.

There might be an argument that Visa and MasterCard are noncompetitive. It is true that Visa and MasterCard have been the subject of some antitrust enforcement action by the U.S. Department of Justice in the past, based on policies they have since abandoned that tried to lock banks into using some of their cards. But these actions have concerned the competitive effect of Visa and MasterCard on banks that issue cards to consumers, and the complaints were resolved years ago with Visa and MasterCard changing the business practices that were considered noncompetitive. (Discover and American Express were the victims of the anticompetitive practices.) The Department of Justice has received many complaints from merchants about interchange fees but generally found them lacking. The high prices that merchants are charged in the United States were found to result in corresponding benefits to consumers. In other words, Visa and MasterCard weren’t keeping those high fees for themselves. In fact, the cut that Visa and MasterCard keep is only about 0.10% of the transaction price — less than one-twentieth of the average fee. Instead, the government found that the interchange fees go bank to the card-issuing banks, and they are actually used there to pay for rewards programs, lower interest rates on cards without rewards, and much lower annual fees. Notably, in countries where the government regulates interchange fees, basically all credit cards have an annual fee. Interest rates outside the United States also tend to be significantly higher.

By the way, I do not work a bank or in any financial services institution. I just think some of the legislation that has come through Congress is fooling the American people into believing that Congress is doing something to help them. In fact, the smart Congressmen know this is just a big giveaway to merchants that will come at the *expense* of consumers. That consumers are too uninformed to notice this is like icing on the cake, because the Congressmen can go back to their constituents and give speeches about how they’re standing up to the big, bad banks — when in fact all they’ve done is found another way to benefit a special interest group at the expense of consumers generally.

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avatar Apex

“Instead, the government found that the interchange fees go bank to the card-issuing banks, and they are actually used there to pay for rewards programs, lower interest rates on cards without rewards, and much lower annual fees.”

Exactly, which was exactly my point and this is both the anti-competitive oligopoly and the inefficiency.

First to the oligopoly. Visa MasterCard control over 80% of all card transactions. Discover is a dying brand and American Express is simply a worse overcharger than visa/mastercard.

Visa/Mastercard set the interchange fees, and you are entirely correct that they give almost all of it back to the banks. Why? Because they want to encourage the banks to hand out cards and to get people to use them as much as possible. This has been going on for 40 years now. Cards are ubiquitous. There is no longer any need to encourage people to get and use cards. Mission Accomplished. So lets examine the evolution of card promotions. In the 80s cards had annual fees, not enough usage to justify the costs to the bank of the accounts so they charged.. In the early 90s many cards went away from the fees because the usage was getting higher and fees were not needed to cover costs. Then in the late 90s rewards started coming out of the wood work. Why? Because fees were now so exorbitantly high compared to the costs of running the business that there was lots of extra money generated by them. So eventually someone realizes they can get more business by incentivising people to use their card over someone else by giving money back (Discover kind of pioneered the concept). Now nearly every card offers a reward so there is no longer much of an incentive to it for getting people to switch to your card but it is industry standard now so you have to do it.

So all the other costs you mentioned may be necessary to cover, but the rewards given back are pure inefficiency in the system. Why do we take 1% extra from the merchant who has to get 1% more from the customer, give it the bank who then sets up an accounting system and rewards program with staff and software and paperwork etc to take that 1% and eventually give it back to the consumer 6 months later as a reward when they have met a $50 threshold? This is digging a hole simply to fill it back up. It provides no benefit at all and just adds cost to the system.

People are going to use their credit card or debit card just as much as they ever did with or without the rewards. There will be lots of weeping and gnashing of teeth if the rewards go away but only for a small whining moment in time. But people are well conditioned now to not carry much if any cash. We whip out the plastic for everything we buy and will continue to do so with or without the rewards. I am not advocating cutting the interchange fees below costs, but there is no reason interchange fees should support a reward/bribe part of the process.

Your only argument that the reward is not inefficient is that it encourages people to use the card but you don’t back that up with any proof. I dispute that claim and see no evidence that it encourages people to use cards over cash because as I said, very few people carry any significant cash at all. And in addition cards already have the added benefit of deferred interest which makes them more appealing than cash.

So please back up the claim that rewards are necessary to encourage credit card usage. I see no evidence of that and without it, rewards are pure inefficiency.

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avatar J

I’m happy to provide you the evidence you request. Respected economists from a variety of points of view recently held an “online symposium” discussing credit card interchange fees. Although the underlying economic theories and quite complicated and probably beyond the scope of what the readers of this blog want to get into, there was a good post by Sujit Chakravorti, a senior economist at the Federal Reserve Bank in Chicago, who described in short form his research finding that “a side payment between the issuer and the acquirer may be required to get both sides on board.” (http://truthonthemarket.com/2009/12/08/the-economics-of-payment-cards-six-lessons-from-the-literature/) He also noted that under several economic models, “the socially optimal interchange fee structure may not be systematically lower than the network profit-maximizing fee.” In other words, lowering fees is actually bad because the economic data suggest that people would use cards less frequently as a result, increasing crime — presumably money laundering, tax evasion, and armed robbery. Some of the economists in other posts also noted concern that under some models, lower interchange fees could end up hurting merchants in the longer run, since consumers with little incentive to become part of one of the four major payment card networks would pressure merchants to accept even more expensive forms of payments such as checks. (http://www.laweconcenter.org/images/articles/zywicki_interchange.pdf; see also http://www.marginalrevolution.com/marginalrevolution/2010/01/more-on-the-economics-of-credit-cards.html)

As for the oligopoly argument, the relevant market against which to compare Visa and MasterCard is not just payment cards; rather the relevant market is “methods of payments,” in which none of those four companies is particularly dominant. There are a lot of different ways you can pay for something, and all of these methods compete with each other. Besides credit and debit cards, you can pay with cash, your personal check, some other kind of draft like a cashier’s check/certified check/travelers’ check/postal money order/etc., via a merchant in-house charge account, a Western Union paygram, an electronic payment from your checking account via ACH, a wire transfer, you name it. For that matter, you could pay with gold bullion or barter if you wanted to and the merchant agreed. Now, yes, I realize that most merchants these days are not going to accept a lot of these forms of payment; try handing over some gold bullion at the checkout line at A&P, and I’m pretty sure you’d get a blank stare. But many of these forms of payments historically were quite common, and there’s nothing to prevent merchants and consumers from switching to, say, traveler’s checks or ACH debits if they thought those payment methods were cheaper. (And remember, merchants can legally say, “1% off your transaction if you pay with an ACH debit or cash instead of a credit card” if they think they would save enough money to make that worthwhile.) The reason that payment cards have become so dominant is that they are actually outcompeting all of these other forms of payment by offering merchants and consumers a convenient, reliable method of payment for a low price. It’s a lot cheaper for most merchants to just pay a small interchange fee and get a guarantee of payment, instead of dealing with all the costs and risks of accepting, say, a personal check that could bounce. Even with cash, merchants have to incur substantial costs for bookkeeping, in-store security, employee theft, counterfeit bills, trips to the banks, bank fees for counting large cash deposits, keeping change on hand at all times, etc. Some merchants actually don’t accept cash at all because these costs are too high.

As for the argument about rewards programs in particular being inefficient, respected economist and blogger Tyler Cowen has a good post about this, arguing that what the payment card networks are basically doing is squeezing a little bit of inefficient monopoly rent out of local merchants by charging fees that get rebated to the consumer. (http://www.marginalrevolution.com/marginalrevolution/2010/01/the-visa-fees-article.html) In other words, Visa and MasterCard are not pushing up retail prices but merely recognize that retail prices are generally a touch inflated because most merchants have some degree of monopoly pricing power, and they organize consumers into networks that can “take back” a little bit of the monopoly rent that merchants would otherwise keep. For example, your local Starbucks has a big fat profit margin because they know there aren’t too many places where you will realistically go to buy a latte in the morning, and the relevant group of consumers is willing to pay more for Starbucks coffee than they would for Dunkin Donuts or McDonald’s coffee. Visa and MasterCard organize consumers into a countervailing market force and require the merchant to give you back a little bit of the inflated price in the form of a rebate. Supporting this view is the fact that discount rates vary significantly from one industry to the next. Low-margin businesses like supermarkets or discount clubs pay lower rates than a high-margin business like Starbucks. This also would explain why merchant groups — not consumer action groups — are the ones up in arms about interchange fees and spending money lobbying Congress to change the law. They can squeeze consumers a little bit more if they are successful.

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avatar Matthew

I would just keep in mind that the businesses do have alternatives. My economics professor was very keen on dispeling the notion of pure monopolies. In reality, the businesses do not have to accept credit cards, they could always be a cash only business or be like a Costco and only accept one particular card to get a reduced processing fee. If the fee was something like 10% many businesses just wouldn’t take credit cards, the fee is what it is because the merchants have decided that it is worthwhile to them to pay a 1.9% fee to accept this form of payment.

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avatar Smithee ♦1,358 (Quarter)

For what it’s worth, I don’t even personally care if the merchants who benefit from this new law pass the savings on to me. I just want more of them to be able to stay in business, especially the non-chain stores which are supposed to be the backbone of our economy.

The banks, Visa and Mastercard will still be making a profit from providing this convenience, but they’ll only be charging the merchant a price that is proportional to how much it costs them to run the network. I would expect the same to be happening for any product or service which I pay for.

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avatar J

The problem is that this is a very regressive proposal. For the reasons discussed earlier, lowering interchange fees does not redistribute wealth from banks and payment networks to small businesses. It redistributes wealth from consumers principally to large megacorporations like 7-11 and Wal-mart, which have been two of the biggest lobbying groups behind the change. (Banks might take a little bit of a hit, but not nearly as much as consumers will get whacked.) This is a very attractive piece of legislation from the perspective of big corporations like 7-11. Because the economics behind it are so complicated, they’re able to trick voters into thinking that they’re doing this to help out consumers and mom-and-pop stores.

Don’t be fooled. 7-11 and Wal-Mart aren’t pumping their shareholders’ dollars into this high-priced Washington lobbyists because they suddenly feel all warm and fuzzy about helping mom-and-pop stores. They’re pumping money into Congress over this because they stand to make a lot more money — mostly at the expense of cash-strapped consumers, including but not limited to low-income consumers struggling to make ends meet who will now get hit with monthly maintenance fees on their checking account — just so 7-11 can make a few extra bucks.

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avatar Apex

Here we go again with this notion that this is just so complex that we common folk can’t possibly know what’s really going on.

In the short run the merchants will benefit because prices will not be lowered immediately. In the long run competition will squeeze the extra profit back to the consumer by having prices rise slightly less than normal until the extra money is removed from the price of the retail products. In the long run the merchants will not really be any better off.

I understand you and your experts are telling us that we are stupid. Retail markets don’t really work. They have monopolies that keep the money and won’t give it back etc.

Fine. Thats what you believe is true. You don’t believe the retail market with millions of competitors dozens in every industry is competitive but the card processing market with 4 processors, two who are the same, one that is dying and one that is a defacto status brand is competitive.

competitive markets work, I can’t help it that you think they don’t or think that markets with few large competitors out compete markets with many competitors.

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avatar Matthew

If we turn this example around, should the Consumerism Commentary website only be charging fees to the companies that run banner ads that are reasonable and proportional to the cost of running the website? An argument could be made that Flexo is charging outrageous fees to the companies who advertise on the site compared to his cost to run the site. There is also nowhere else to get his commentary, so he’s got a monopoly going that the government should be allowed to regulate.

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avatar Apex

CC is no monopoly. There are billions of sites advertisers can go to. CC does not participate in any practices that enforce a monopoly position. CC does not take any actions that damage consumers or prices paid by consumers.

Visa/Mastercard set prices explicitly for what it costs to run charges through their network. They control over 80% of all CC transactions and getting larger every year. They use those charges to bribe banks into taking their cards keeping very little of it for themselves, then they tell merchants they cannot engage in tiered pricing models based on payment choices and that they must pay the full interchange fees to use their payment system and they are mostly the only game in town and this system has been used over the last 4 decades to slowly entice very consumer to use this payment system almost exclusively. The merchants raise their prices to cover this cost which is price fixed by Visa/Mastercard. This does damage to the consumer. That is the definition of an anti-trust violation and gives the govt jurisdication.

Once you show CC has done damage to the consumer which would then violate the 1934 anti-trust laws, you would have a valid analogy. But without that connection you just have an irrelevant fable.

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avatar Apex

“First, a side payment between the issuer and the acquirer may be required to get both sides on board. In this case, the side payment is the interchange fee. This side payment may skew the prices paid by end-users.”

He is talking about the interchange fee not the rewards paid to consumers and he blatantly admits it may raise prices to the end users.

Further Cowen talks about the petty monopoly of the retailers and makes the following very blatant belief:

“And I find it easy enough to believe that the petty monopoly of the local grocer is more significant than the market power in the potentially more contestable cards and payment market.”

So there it is plainly. He believes retailers have a monopoly pricing power that outweights the monopoly payment fee power of the major card networks. He uses the word believe.

Why he believes this is not clear to me and frankly baffling but it is what it is. But lets just assume he was correct. Well if he was then the retailers can simply use their monopoly pricing power to raise prices even more to get back that fee that has now been imposed on them.

But instead he believes that in some act of kindness, visa and mastercard have appeared on the scene to encourage the banks to extract some of the extra profit the retailers have been using their monopoly power to receive and to return it to the consumers (mind you the banks only saw fit to do this for the last 15 years or so, before then they were fine keeping that extra profit for themselves). But once this extra profit was extracted from the retailers, their monopoly power had apparently become impotent because it did not have the power to increase prices to get that extra profit back. I guess the monopoly power (which he calls petty monopoly) is a special kind of pricing power that lets you take a very small extra profit apparently about the size of the extra fee that is extracted in credit card transactions but no more than that. The monopoly power is exhausted after that.

So we appear to have competing beliefs. Those on one side believe that the fees are providing some benefit. They believe in special kinds of monopoly power that can have their profits extracted without being able to get new profits and they believe that price setting of payment fees by a controlled payment system where 80% of the market is controlled by one entity does not grant any kind of monopoly power with any kind of negative affects for consumers.

I believe the opposite.

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avatar J

OK. It is not uncommon in academic circles for professors and researchers to qualify their statements by saying, “I think this” or “I believe that.” So you will see that qualification made for some of the statements. (Incidentally I think the Zywicki article doesn’t qualify his arguments with “I think,” but I don’t think it matters.) The point is, these are experts in this field with advanced graduate training in economics who in many cases have spent months or years researching various aspects of credit card interchange systems and come to the conclusion that the current system is actually beneficial and that changing it will make us worse off as a society. You don’t have to agree with everything an expert says, of course, but I think it’s a little silly to just say, “Well, they only said they *believe* this is true, and I with no economics training and having never studied this issue just have a different belief.” Yes, you’re entitled to your own opinion, but I don’t think we should just dismiss serious economic research because we don’t like it without having some reason to think that it’s wrong.

The only reason you mention for why you think it’s wrong seems to center on the idea that, if local merchants have monopoly pricing power, then why can’t they just raise prices even more when Visa and MasterCard come along and impose these fees on them. First of all, I think you’re assuming that the fees Visa and MasterCard charge work out to be a price increase on the merchant; it’s actually fairly complicated, and you can make a case that a lot of merchants actually save money in their business overall by accepting cards relative to the cost of handling a lot more cash and dealing with security/theft/counterfeiting/longer checkout lines/etc. that go along with that.

But even if we assume that the fees operate in some fashion as an increase in cost, whether the merchant can “pass along” that increase in cost depends on the market structure in which the merchant operates. Counterintuitively, if the merchant has pricing power, they get stuck “eating” most of the cost increase themselves. That’s because they’re already charging the highest price they can get away with. Customers of, say, Starbucks aren’t necessarily going to pay $10 per latte instead of $3 because the price of beans has gone up from 30 cents a cup to $1 a cup. I’m oversimplifying slightly because there are complicated issues about what’s known as the “price elasticity of demand,” so you can’t rule out the possibility of some small increase in the price paid by consumers. But in addressing merchants with pricing power, at the very least *most* of the cost will be paid by the merchant and he won’t be able to pass that on to the consumer. *And* if the price the consumer pays goes up by less than the rewards and other perks they pick up on average, consumers are better off.

You repeat this “80% of the market” statistic. Again, you are not defining the market correctly. I suppose some people would say that Apple has “100% of the market” for iPhones, since you can’t buy iPhones from anyone else. But the point is, you can get a Droid or a Blackberry or any number of other phones, and compared to that universe, Apple’s market share is actually pretty small and there are a lot of competitors out there. Likewise with payments. There are four credit card processors — which is normally considered a pretty good amount of competition, to be honest with you; there are lots of industries with fewer than four real competitors. But even apart from that, merchants could decide they prefer checks or direct ACH debits to consumer checking accounts (the technology does exist for that sort of thing), or even just stick to cash. All of those are viable competitors to cards. Just because a lot of people prefer cards doesn’t mean that the card companies have some sinister monopoly. It just means they’re providing a service people find useful — just like a lot of people really like the iPhone or the Blackberry or whatever.

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avatar Apex

yes there are other payment choices other than credit cards. There are also other transportation means other than cars but people don’t talk about bicycle and airplane manufacturors as competitors to GM. Credit cards are the predominate preferred retail payment system (and they will continue to be with or without rewards programs by the way). Nothing else is even remotely close. There are only 4 processors. Visa/Mastercard are basically the same one, Discover is a dying brand, and AMEX is a preferred status brand. There is almost no competition here. Almost none. But you can keep saying there is, it won’t make it true.

Economic experts? Is that an oxymoron? Those economic experts did pretty well in warning us about the dot.com bubble, in telling us there was no housing bubble, in telling us that the new “innovations” in debt risk distribution had allowed us to assess risk in new ways and spread the debt market to new people who were previously unable to have their debt risk properly assessed. Lies lies and damn lies. Their debt risk has been properly assessed for centuries, its horrible. But those economic experts told us that the past was wrong and this was different. It’s not different. It never is.

And economics is a pretty hard science with very proven methodologies like the rational actor, and efficient market hypothesis, etc.

What has been shown to be true in markets for a very long time is when a market is immature, it needs excessive pricing to survive. This was true of the credit card market early on and is why the high interchange fees were necessary. When a market starts to mature, prices come down, slowly at first and then, when it reaches commodity status, prices are squeezed down until there is very little profit left in the system. Credit cards are at the commodity stage. They are ubiquitous and they are perform exactly the same function. Banks offer different little perks and little rewards (funded by their over charging fee structure) but they are all the same at their core. Yet there is no reduction in the cost of the product. This violates basic economics and doesn’t follow the example of every other type of open market for mature products, yet there are some experts that assure us great damage will occur if we let prices of interchange fees fall like prices fall in every other industry and every other product. Credit cards are apparently super special and super fragile with respect to their impact in the overall payment system, and economic impact.

A perfect example is the long distance companies of the late 90s. They had been overcharging the market for long distance phone rates for years. There were 3 big companies, AT&T, Sprint, MCI, and then a bunch of qwest baby bells. (4 competitors is more than enough right, so 3 bigs a bunch of baby bells should do it). 25 cents a minute maybe down to 15, for years and years and years. How did they do that. Long distance was clearly a commodity. But the companies controlled the long distance lines and did not have to allow outside competition so they all just operated on the same fat margins. But then the government decided that they had operated a near monopoly long enough and passed a law requiring them to open their lines to any outside company that wanted to lease their lines. The 10-10 companies popped up all over the place and drove prices down to 3 cents a minute. And all the long distance providers went broke because they didn’t know how to operate on those margins, but other companies did and were able to provide the service just fine.

The credit card companies have the exact same type of monopoly power. No one else can offer credit card processing because the interchange fee structure gives them no reason to do so and no bank would take someone else’s processing and get lower fees so Visa/Mastercard essentially hold all other commers out of the market.

So yes, some experts claim to have some kind of model that shows that everything we know about how products function in a market as they mature is wrong when it comes to credit cards. They violate all the basic rules that apply to every other industry and product.

So, when supposed experts in a field with a lousy track record of expert analysis tell me that everything I know about basic economics is different this time, I have no problem positing my non expert reasoning as to why they are simply full of it and wrong.

I am a strong market supporter but this devotion that some people have to market purism where markets are always right and in no need of outside regulation is really a baffling idealogical viewpoint that is mostly shared by people who tend to have the same idealogical view as me on other topics but on this topic history has shown us repeatedly that markets when left entirely to themselves, are manipulated by greed and corruption to bend them to the will of those who have been given undue influence over those markets.

Credit card processors have a position of power that gives them undue influence and you can be they are using it to bend that market to their will, and I assure you, their will has nothing to do with the benefit of the consumer.

I have stated my reasons and I stand by them. I don’t expect to convince you of anything. But I am not even remotely impressed by expert economic analysis that doesn’t make any economic sense to me at all. Perhaps I am just not smart enough to know what they know. But I saw the bubbles coming when they didn’t, so I tend to trust my economic read a lot more than what the experts say.

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avatar Apex

Federal Reserve Bank of Boston has a study that shows credit card fees and reward programs transfer money from poor to rich:

http://news.yahoo.com/s/nm/20100726/lf_nm_life/us_usa_fed_wealthtransfer

Some things just aren’t that complicated. They are right there in front of you. If you charge more money for a service that goes into the cost of the product. If you don’t believe that then lets put on a VAT tax, the retailers will just have to eat it cause they don’t have pricing power and it will just take away from their already inflated monopoly power pricing. Presto, we can solve our budget problem with a VAT tax and the fees won’t be paid by the consumer but by the monopoly power retailers.

Why have we not thought of this sooner? Cause it’s retarded. This argument that costs are eaten and not passed on is really silly. When some people get a kick back cause of their payment type and others don’t then those that didn’t get a kickback paid extra to subsidize those that do get a kickback. 2+2 really does equal 4. It takes an economic expert to tell you it equals 5.

I don’t know that the Federal Reserve of Boston study is necessarily any better than your experts, but the point is, I can find studies that show the significant harm to consumers from high interchange fees. But the fundamentals of basic economics are on my side and can be plainly explained without referring to some economic expert and complex systems that no one can understand and must just take on blind faith due to their PhD.

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avatar Matthew

A lot of the discussion here assumes that the rewards that are earned by cardholders are paid for from interchange fees. Do we really know what percentage of the rewards are funded by these processing costs versus what is generated from charging interest on the account balances? I always thought of the rewards programs as a way to entice you into running a balance on your card and paying interest to the bank. Rewards cards also typically have a higher interest rate which lends weight to this approach.

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avatar Apex

Why not offer 3% rewards on a 15% card and 5% rewards on a 20% card then? Cause people who don’t carry a balance would just get the 5% card.

Is it any coincidence that other than a couple special categories like gas and groceries, that the fees average 1% or less across all cards and that the interchange fees are charging a rate of somewhere between 1 and 1.5% above the cost of doing business by most estimates? I don’t think so.

But there is an easy way to test it. Drop the interchange fees by 1% (the rate of most rewards). I will take a bet with all comers that in that environment most of the rewards paid on cards go away and any that remain are only for very special circumstances.

If you are correct then they should just raise the interest by 1 or 2 percent and keep the rewards.

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avatar FactChecker

The easiest way to look at this is Australia, where interchange fees have become an unearned source of profit for retailers, in which credit card users subsidize people who use other methods of payment, or in most cases there is no other method of payment such as hotels.

There are no rewards cards in Australia , the cards that advertise themselves as rewards cards cost a lot more than the benefits, according to a recent Sydney herald article. Instead, retailers not only surcharge the interchange fee (thus getting a benefit for nothing since cash and checks aren’t free which the national retail foundation ignores) but often charge 3x the fee such as hotels and taxis.

Those who say people should ignore plastic are blinded by reality to an extent, if you can carry cash you get mugged, stolen, etc, of course cash is not going away, and many businesses are still cash only, especially small item, and stores that sell goods such as jewelry and food and who do tax evasion on the side.

A credit card offers a grace period thereby helping low income folks (in Australia interest begins at day one), protection against fraud (in Australia interest not only begins at day one but pays for fraud costs), extended warranty and protections (a “rewards” card is not necessarily a cash back card in which a cost is lower, a card can offer these features instead), etc.

Rewards cards often have the same fee as non-rewards cards at lower interest, they key is certain cards or premium cards may carry a higher fee, such as travel, business, platinum, signature cards. Many low income student cards are rewards cards, a high interest card it may be, but paying the balance in full within 3 weeks can avoid that scenario.

Ever wonder why Stores themselves have rewards credit cards? Stores are allowed to give cash and check discounts, a few do so any talk of not being able to do s nonsense, major retailers know that card users may spend more money using the card, and they know that cash, check, etc has costs such as theft, accounting, security services, safe deposit, etc, checks have float and fraud costs.

So if cash and check are 1% a cost of doing business, then the national retail foundation is misleading folks, implying that its just pure profit. Go to the national retail foundation’s website and type in cash cost , its buried under there.

Maybe we should regulate fedex and UPS, require them to allow boxes of almost any size, require them not to pass surcharges for profit, require certain hours, certain policies, etc. After all they are a network. Its important to remember that the Australia RBA was not designed to lower costs for consumers. A GOA study indicates that interchange Aussie style won’t necessarily lower consumer prices.

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avatar Leton

Coffee at convenience store cost 10 cents to make. Sells for a dollar. You figure the mark up. So interchange doesnt seem so high does it?

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