UnintendedConsequences:
Regulatory Failures
First Quarter 2007
InterchangeRegulation: LessonsLearned From RBA
Intervention inAustralia
Alternative Approaches to Interchange Fee
Regulation
Intended ConsequencesVersus
Actual Outcomes
Ongoing research and analysis on global economic dynamics,business conditions and public policy challenges
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n the last few years, government authoritiesaround the world have started to pay attentionto the regulation of credit card interchange fees.Prior to such regulatory attention, credit cardschemes were largely self-regulated, albeitsubject to close antitrust scrutiny and intense
competitive pressure. Leading the drive toregulate the interchange fee has been theReserve Bank of Australia (RBA).
The RBA intervention in interchange wasinitiated by the report of the Wallis FinancialSystem Inquiry in 1997, which recommendedthat the credit and debit card interchangesystems be reviewed by the AustralianCompetition and Consumer Commission(ACCC). In 1999, the RBA and the ACCC,announced a joint study into, amongst otherthings, interchange fees and membershipcriteria for credit card schemes.
In 2000, the RBA and ACCC published “Debitand Credit Cards Schemes in Australia–– A Studyof Interchange Fees and Access.” The reportasserted that (i) interchange fees were not inline with costs, (ii) competitive pressures wereinsufficient to bring interchange fees to reflectcosts, (iii) no surcharge rules were undesirable,and, (iv) access to membership to the creditcard schemes was too restricted. Following thepublication of the report, ACCC recommendedthat the RBA use its power to regulate the creditcard systems in Australia. In 2001, the RBAbrought the payments systems operated byMasterCard, Visa and Bankcard, all four-partypayments systems, under its regulation. TheRBA chose not to regulate American Expressand Diners Club because there are no explicitinterchange fees in these three-party paymentssystems. In 2002 the RBA announced itsregulation; which focused primarily on theadoption of a new approach to interchangecalculation, the elimination of the “no surchargerule,” and changes to Australian banking laws tofacilitate greater access to four-party schemes.
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Interchange Regulation: Lessons LearnedFrom RBA Intervention in Australia
Legal challenges to the RBA regulations byMasterCard and Visa were unsuccessful and theregulatory measures came into effect in 2004.Almost three years have passed since the RBAregulatory measures were implemented, andthere is now sufficient data to assess the impactof some of these measures. As will be detailed,not only have these regulatory measures beenineffective in achieving the intended results asstated by the RBA, market data also suggeststhat a number of very negative unintendedconsequences have emerged. These outcomescan only be described as regulatory failures; andAustralia is now saddled with a more expensive
payments system that delivers fewer benefits tocardholders, distorts market competition,suppresses technological innovations, and allowslarge merchants that enjoy near monopolymarket power to take advantage of the situationto gouge customers.
RBA Regulationand Intended Results
The RBA regulatory measures and intendedconsequences can be summarized as follows:
Regulatory Measure #1Reduction of interchange from 0.95% to 0.55%.The rationale used by the RBA is that theinterchange fee has to be “cost-based,” and this
puts the RBA as the penultimate judge of whatshould or should not be considered as a “cost”for doing business. Reducing the interchange feefrom 0.95% to 0.55% is based on the RBA’sdecision of what should not be included as“costs” of doing business.
Intended Consequences1. Merchant fees would be reduced which wouldthen be passed onto consumers, resulting inlower prices for all.
2. Debit cards usage would expand while creditusage would decline, which in the RBA’s opinionwould be a more “efficient” outcome given debitcards are cheaper.
3. With a reduction of the four-party schemes’interchange, the cost of accepting three-partyschemes would follow suit without regulatoryintervention.
Regulatory Measure #2Elimination of the “no surcharge” rule. The RBA believes that this will allow merchantpricing, with surcharging, to reflect moreaccurately the “true cost” of accepting creditcards, thus ending what the RBA sees as “cross-subsidization” of credit card users byusers of other payment instruments.
Intended Consequences4. Merchants would judiciously surcharge foraccepting credit cards; and in so doing, makecredit usage less attractive than debit cardusage; which would in turn encourage higherdebit card usage.
Regulatory Measure #3Easing of “restricted access” to four-partyschemes, which Australian banking law
2
Australia is now saddled with a more
expensive payments system that delivers fewer benefits
to cardholders
previously restricted to authorized deposit-taking financial institutions.
Intended Consequences5. Facilitate new entrants to memberships of the four-party schemes, thus increasing marketcompetition.
Intended ConsequencesVersus Actual Outcomes
As mentioned above, a significant body ofevidence has been compiled with which theintended consequences of the RBA regulationcan now be assessed against actual outcomes.These assessments are summarized as follows.
Intended Consequence 1Merchant fees would be reduced which wouldthen be passed onto consumers, resulting inlower prices for all.
Actual OutcomeMerchant service fees dropped as per RBA’sregulatory measures, but the actual outcome has been completely different from what theRBA intended. Over the 2003 to 2004 period,
when the merchant service fees declinedsubstantially, research data shows that some70% of merchants were not even aware of it,and in fact believed that there had been nochange in their merchant service fees.
2Thus, the
RBA’s entire hypothesis that merchants would pass their reduced merchant service fees to
consumers in the form of lower prices could notbe substantiated by empirical evidence.Furthermore, the annual reports of Australia’sretailers, clearly showed that any decrease intheir costs (therefore including reductions inmerchant service fees) are immediately used to improve their bottom lines.
Intended Consequence 2Debit card usage expands while credit usagedeclines. In the RBA’s view, debit cards are amore “efficient” payments card than creditcards.
Actual OutcomeThe evidence suggests that the opposite hasoccurred. According to the Reserve Bank’s owndata in 2002, the year prior to the regulations,debit card payments including cash withdrawalscomprised 57.2% of total card payments withcredit cards comprising the remainder with42.8%. In 2006, debit card payments had fallento 55.3% of total card payments.
Intended Consequence 3With a reduction of the four-party schemes’interchange, the cost of accepting three-partyschemes would follow suit without regulatoryintervention.
Actual OutcomeMerchant fees charged by three-party schemesdecreased only marginally, from 2.7% in 1999 to 2.33% in 2005, compared with a decline from1.8% to 0.98% for the four-party schemes overthe same time period. Meantime, three-partyschemes have been taking advantage of thehigher annual fees charged by issuers of four-party schemes (see Regulatory Failure #5)
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The actual outcome has been completely different from
what the RBA intended
and raised their annual fees. MasterCard’s ownresearch has seen increases as high as 120%.
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Intended Consequence 4Merchants would judiciously surcharge foraccepting credit cards; and in so doing, makecredit usage less attractive than debit cardusage; which would in turn encourage higherdebit card usage.
Actual OutcomeWhere merchants have introduced surcharging,it has been arbitrary and non-systematic. Manymerchants have introduced differentialsurcharging by brand, while many others do not offer clear disclosure of how they surcharge,
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making a mockery of the RBA’s aim of makingthe four-party schemes more “transparent” and“efficient.”
Furthermore, surcharging has been prevalent in markets where merchants do not face strongcompetition, such as Qantas and Telstra. Mostretail segments, which typically face the highestlevels of competition, see very little or nosurcharging.
Intended Consequence 5Facilitate new entrants to memberships of the four-party schemes, thus increasing marketcompetition.
Actual OutcomeThere have been no new entrants of significant size into the Australian market as a result of the RBA regulation. Quite to thecontrary, as discussed later, the credit unionindustry is exiting credit card issuing, while the Bankcard brand has also recently been shut down.
Unintended Consequences:
Regulatory FailuresThe RBA intervention also has manyunintended, but potentially highly damaging and anti-competition consequences that canonly be described as regulatory failures. These regulatory failures, as described below,had actually been anticipated by MasterCard.
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These are summarized as follows.
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Regulatory Failure #1:Creating Artificial and
Unfair Competitive Advantagesfor Three-Party Schemes
By imposing direct regulatory interventionselectively on the four-party schemes withoutaddressing the three-party schemes, the RBAhas created competitive advantages for thethree-party schemes. A rapidly expanding bodyof evidence suggests clearly that the three-partyschemes have been increasing their market
share at the expense of the four-party schemes.Three of the four largest issuers have moved apart of their issuing to three-party schemes; theircollective share of issuing three-party-schemecards has grown since the RBA regulations.
6Given
the RBA’s stated purpose of making fee structuremore transparent, and given that the feestructure of three-party schemes is completelyopaque, whereas information on the interchangefees of four-party schemes is regularly reportedand accessible to the public, the artificial and unfair competitive advantages created by theRBA in favor of three-party schemes areparticularly troubling. In its submission to the RBA in 2002, MasterCard pointed out that large issuer-acquirers would be motivated torecover lost interchange fees by either partneringwith the unregulated three-party schemes, ordealing directly with merchants and focusing on“on-us” transactions thus effectively creatingtheir own three-party schemes.
7While Australian
issuers have not formed their own three-partyschemes, MasterCard’s warning was directionallycorrect as several large issuer-acquirers inAustralia have become issuers of the moreexpensive closed three-party-scheme cards suchas American Express and Diners Club since theRBA regulations.
Regulatory Failure #2:Hurting Small Players in the
Four-Party SchemesMasterCard warned in 2002 that RBA’s newinterchange regulation would make itcommercially unviable for small issuers, leadingto market consolidation, hence less competitionin the payments market.
8The recent demise of
the Bankcard scheme (a previously profitable
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portfolio) and the acquisition of the smallCUSCAL and Bank of Queensland credit cardportfolios by Citibank, suggest that, as predictedby MasterCard, smaller operators have found it increasingly difficult to remain profitableunder the new RBA regulations.
9By ignoring
the competitive process that already existed in Australia, the RBA regulation has createdunnecessary and undesirable market distortionswhich in turn undermine market competition.
Regulatory Failure #3:Creating Artificial and
Unfair Competitive AdvantagesBetween Larger and Smaller
Four-Party SchemesBy setting an arbitrary level of interchange feeto be followed by four-party schemes, the RBAregulation has created a potentially disastrousloophole that advantages one regulated four-party scheme over another merely due todifferences in their respective portfolio makeup.This is because the artificially set interchangefee level is an average of several interchangefees for different cards: premium, business, and standard cards, for example. A scheme with a lower share of premium cards than its competitor, can significantly raise theinterchange fee for the premium cards toencourage and reward issuers that aggressivelypush their issuance, while lowering theinterchange fee only marginally (hence withoutunduly discouraging issuing) in the standardcards to compensate for the higher interchangefee for the premium cards, and in so doingachieve the required average. MasterCard hasalready encountered competitive pressure inAustralia as a direct result of the RBA’s poorly
conceived regulation. Thus, the RBA regulation has created a situation where the previouslymore normal competitive process has beensubverted to benefit one player in the paymentsmarket; contradicting directly the RBA’s statedregulatory objective of making the market morecompetitive and in the process proving that it isimpossible to predict the consequences of theregulatory intervention, and why such regulationshould be the absolute last recourse. Of coursein Australia, the RBA and ACCC embarked on ahighly interventionist regulatory and price-setting exercise without first giving the industryan opportunity to address any of the perceived“inefficiencies” of the existing setup.
Regulatory Failure #4:Retarding Technological Development
and InnovationsMasterCard warned in its submission to the RBA that squeezing the interchange fee couldpotentially retard technological development and innovations in the payments industry, andnegatively affect Australia’s e-commerce growth.
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While it is difficult to assess at present whether e-commerce growth has been affectedby the RBA regulation, what is clear is that thedevelopment of technological innovations in the payments industry have been retarded. As othermarkets, in Asia and elsewhere, have beenrapidly adopting new technologies such as chipand EMV over the past several years, no suchdevelopments have occurred in Australia.
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The normal competitive process has been subvertedto benefit the largest player
in the payments market
Regulatory Failure #5:The Entire Payments System Has Become More Expensive
Contrary to the RBA’s intention of making thepayments system more efficient and increasingcompetitive intensity, the exact opposite hashappened in Australia. In addition, the paymentssystem has actually become more expensive for the average cardholder. While there is noevidence of retail price reduction by merchants (so confidently predicted by the RBA), there iswidespread acknowledgement that issuers haveactually increased fees to cardholders tocompensate for lower interchange fees since theRBA regulation. Examples include:
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• Commonwealth Bank: Annual fee on itsstandard card increased from AUD46 toAUD59. Interest rates charged on cards(Commonwealth Awards and CommonwealthAwards Gold) have also increased by morethan increases in the official cash rate.
• Westpac: Annual fee on its Gold cardsincreased from AUD65 to AUD90, andannual fee on its 55-day interest-free Visacards from AUD24 to AUD30.
• ANZ: Annual fee on its ANZ First FreeDays Visa cards increased from AUD28 toAUD30, Qantas Visa cards from AUD67 toAUD95; and fees for late payment and forexceeding credit limits increased by AUD10each.
For most issuers, the rewards programs havebeen downsized, and in some instances verysubstantially. In addition, cardholders aresubjected to random surcharging at the point-of-sale for various credit card transactions.
From the cardholder’s point of view, the netresults of the RBA regulation have beenincreased costs, reduced benefits, and nosavings.
Reflection on RBA’s Regulatory Failures
As summarized in this report, a growing body of market data and evidence suggests that theRBA’s regulatory intervention in setting theinterchange fee in Australia has resulted inmultiple regulatory failures. The interventionhas failed to achieve its intended objectives(regardless of whether these objectives arejustified); and has created an extensive range of unintended and negative consequences. Upon
reflection, the failures of the RBA regulationstem from a serious misunderstanding of thenature of the credit card industry, aggravated byregulatory zeal to engage in social engineering––deciding for all Australians what is really goodfor them in terms of payment options. The keymistaken interpretations are:
• A failure to understand that the four-partycredit card system is subject to intensecompetition–– externally with other paymentoptions, including two-party and three-partypayments systems and cash; and internallybetween issuers and acquirers. Such intense
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The intervention has failedto achieve its intended
objectives and has created anextensive range of unintended
and negative consequences
competitive pressure has led to the rapidevolution of the four-party credit card system inthe past decades, both in terms of technologyand in meeting customers’ needs with highlyfocused and increasingly beneficial services, inthe complete absence of regulatory intervention,apart from sporadic antitrust scrutiny.
• The line of credit feature of the credit cardsystem is neither a marketing gimmick nor a luxury as often implied by the RBA, but aprofound financial innovation. It enhancespurchaser liquidity, and, as such, it delivers a net benefit to the economy, includingmerchants that accept credit cards.
Appendix:Alternative Approaches toInterchange Fee Regulation
During the process of the RBA intervention ininterchange fee regulation, a number ofapproaches to the setting of the interchange feewere proposed. These are summarized briefly as follows.
Common notations:
The MasterCard ApproachMasterCard proposed to the RBA that it setAustralian interchange fees using its traditionalcredit card cost-based methodology, in whichthe weighted average of interchange fees in
Australia not exceed the measured issuers’ costof providing a payment guarantee andprocessing transactions, plus the cost of fundingthe interest-free period; or
Fi = c I + (opportunity cost of capital for funding
the interest-free period)
And where c I equals to the sum of the costs ofproviding a payment guarantee (including costsof fraud and credit write-off), and the costs ofprocessing transactions from acquirers.
The ACCC ApproachThe ACCC proposed that the interchange feesshould be set by a comparison of the costs ofissuing and acquiring with the revenuesobtained by the issuers and acquirers; and thatthe interchange fee is the offset of any revenueshortfall of either the issuers or the acquirers.
Thus, if R I < c I + C I , then F i = c I + C I -- R I .
Alternatively, if R A < c A + C A , thenF i = c A + C A -- R A .
If, however, both R I > c I + C I and R A > c A + C A , then F i = 0.
Implied in this approach is that the interchangefee should be a “balancing transfer” that restoresthe “balance” between the different parties. Howmarginal and fixed costs are to be defined is notspecified, nor is the issue of how to aggregatethe different marginal and fixed costs of thedifferent issuers and acquirers (especially whenthey use different definitions) addressed.
The Australian Banking Association (ABA) Approach
The ABA proposed that the interchange fee becapped at the stand alone cost of providingpayment functionality and should be no lower
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Interchange Fee
Marginal Costs of Issuers
Average Fixed Costs of The Issuers
Average Revenue of The Issuers
Marginal Costs of Acquirers
Average Fixed Costs of Acquirers
Average Revenue of Acquirers
F i
c I
C I
R I
c A
C A
R A
=
=
=
=
=
=
=
than the incremental cost of that functionality.The costs to issuers in this approach includefraud costs, credit losses, cost of funding theinterest free period, operating costs, marketing,promotion and retention costs (including costsof funding loyalty programs), and the costs ofequity capital and sunk costs.
In this approach, while the interchange fee is tobe capped at
Fi = c I + C I (opportunity cost of capital for
funding the interest-free period),
it allows all issuer costs associated with paymentfunctionality to be passed through to acquirersand merchants.
The RBA ApproachThe RBA rejected all the preceding approaches.
The RBA, in presenting its own approach tosetting the interchange fee, argued that:
(i) Costs associated with credit losses on unpaidcredit card debt related to the line of creditshould be “recovered” through interestpayments by revolvers, and not all creditcardholders.
(ii) The interest-free period is seen as a costassociated with providing a benefit purely to thecardholders and therefore should be recoveredby fees charged to the cardholders.
(iii) The costs of funding loyalty programsshould not be allowed to be included as a cost.
(iv) Cost of capital should not be included ininterchange fee.
The RBA’s approach defines the interchange feeas comprising of a narrow definition of marginal
cost for the provision of payment functionality,net of costs associated with the line of credit,and only to the extent that such marginal costsare attributable to merchant benefits. Thus, RBAbelieved that it is in a better position than themarket and its consumers in deciding whatshould and should not be considered as “costs”in doing business in Australia.
Apart from practical difficulties such as how toseparate credit cardholders into “revolvers” and“transactors” in advance; the RBA in the enddeviated from its own principles and, as far as it can be understood, accepted the costsassociated with funding the interest-free periodon a completely arbitrary basis.
1. See Appendix for a summary of the different approaches to
setting the interchange fee proposed, and how they compare with the
RBA approach.
2. “Tracking Study on Credit Card Surcharging and the Interchange
Fee,” Roy Morgan Research, August 2005. Also see
www.rba.gov.au/statistics/bulletin/C03hist.xls
3. See www.rba.gov.au/statistics/
4. “Tracking Study on Credit Card Surcharging and the Interchange
Fee,” Roy Morgan Research, August 2005.
5. MasterCard 2001 Submission to the RBA.
6. The expansion of the three-party schemes at the expense of the
four-party schemes is supported by RBA’s own data; please see
www.rba.gov.au/statistics/bulletin/C02hist.xls.
7. P.32, “Response to the RBA’s Consultation Document,” MasterCard,
2002.
8. “Response to the RBA’s Consultation Document,” MasterCard, 2002.
9. “Estimation of Credit Card Industry Market Share,” June 30, 2006.
Ernst & Young.
10. P. 23, “Response to the RBA’s Consultation Document,” MasterCard,
2002.
11. “Interchange in Australia–– Global Implications,” Datamonitor,
March 2005.
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Ongoing research and analysis on global economic dynamics,business conditions and public policy challenges
For additional copies of Insights or for additional information contact Ms Georgette Tan,MasterCard Worldwide at [email protected] or you can visit www.masterintelligence.com
