Few consumers would have noticed a very important reform discussion taking place in Australia. It is a debate relating to credit card interchange fees. The fact that most consumers have never heard of interchange fees is the reason regulators think that they might be a problem.
Interchange fees are the fees banks pay to each other when their clients engage in a credit card transaction. Credit cards operate in what economists call a two-sided market. Consumers must want to pay by credit card, and merchants must want to receive payment by credit card. Payment mechanisms include cash, debit cards, and credit cards. Consumers often have to be incentivised to hold credit cards, and banks offer various inducements such as interest-free periods and loyalty points for using credit cards — and that is where the interchange fee comes in.
Increased use of credit and debit cards increases the size of the market — everyone is better off as a result. The interchange fee operates to share those gains from an increased market between the banks that provide the cards and the consumers who use them. Merchants sell more goods and services, banks get profits, and consumers enjoy various credit card rewards. This sounds like a win-win-win situation.
But, not so fast.
Everyone wants something for free. So merchants would like to enjoy the benefit from the increased size of the market but not share those gains with consumers and their banks. The interchange fee that incentivises consumers to use credit cards — and their banks to issue them — is ultimately a cost to merchants. Any cost saving flows straight through to their profit.
TOO MUCH CREDIT CARD USE
By the early 2000s the Reserve Bank of Australia had formed the view that there was too much credit card use in Australia. Not necessarily that consumers were running up too much debt per se, but that consumers should rather be using cash or debit cards for their transactions. Their view was that banks could profit more from credit card interchange fees and so offered excessive rewards for using credit cards. The RBA has always felt credit cards are an expensive payment mechanism relative to cash transactions. So, all up, excessive usage of a high-cost payments mechanism was believed to be adding unnecessary costs to the economy.
The "villain" in this piece is the interchange fee. It was said to be opaque and excessive and because consumers didn't know about it, or even care, interchange fees were labelled as being "anti-competitive" and then regulated.
Since then credit card users will have noticed many changes. Credit card fees have increased, reward programs have been scaled back, merchants often charge excessive credit card surcharges, and the gap between credit card interest rates and the cash rate is higher. To be fair, the increase in the interest rate gap isn't entirely, or even mostly, because of the RBA regulations, but we think nearly 1 per cent of the increased gap is because of the regulations. Consequently there has been a relative decline in credit card use since the early 2000s. That was the policy intent.
What of the promised benefits? One benefit was that retail prices should have declined. The argument being that cash customers were subsidising credit card customers through higher prices. Not only is there no evidence to support the notion that retail prices are lower as a result of the RBA regulations, but it now concedes that it would be impossible to measure the magnitude of any flow-through benefits to consumers. By contrast, the RBA has been able to determine that merchants have saved $13 billion as a result of their regulations. However that saving, not having been passed on to consumers in the form of lower prices, must simply have gone to increased merchant profit.
So all up we have had a "reform" that led to higher consumer costs and higher business profit.
DIDN'T UNDERSTAND
The reason for that outcome is simply that the RBA didn't understand the underlying economics of the issue. To be fair, it wasn't alone in that, but the RBA was a pioneer in regulating interchange fees. We know now that it got it wrong and we know why it got it wrong.
As the famous economics laureate Ronald Coase observed, when economists see something they don't understand they tend to look for monopoly explanations. The RBA didn't understand that the long-term relationships between banks and their customers — be they credit card users or merchants — are competitive, efficiency-enhancing relationships. The RBA didn't understand that consumer sovereignty is not monopoly power in need of regulation. It didn't understand that if and when it weakened consumer sovereignty merchants would simply pocket the so-called savings and not pass them on to consumers in the form of lower prices. It didn't understand that the alternative to a credit card transaction isn't a cash transaction, but rather the merchant having to offer credit, or no transaction at all.
In short, the RBA credit card regulatory interventions were based on wishful thinking and anti-bank prejudice. It has added costs to consumers but there were few, if any, benefits and the move should be reversed.
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