Submission to the Senate Inquiry into Matters Relating to Credit Card Interest Rates

Senate Economics References Committee

Credit cards as payment instruments

Use of credit cards

In recent decades there have been significant changes in the way that individuals, businesses and government agencies make and receive retail payments. The use of non-cash payment methods has increased strongly, with debit and credit cards playing an increasingly important role in the payments system. They are now the most frequently used non-cash payment method, accounting for around two-thirds of the number of non-cash payments in Australia in 2014/15 (though only around 3 per cent of the value, given the small size of card transactions compared with some other payment methods such as electronic funds transfers). Over the past financial year, Australian personal and business cardholders made around 6.2 billion card payments, with a total value of $503 billion. Credit card payments accounted for 2.2 billion payments with a total value of $285 billion.[4]

The growth of credit card use was especially strong in the 1990s and early 2000s (Graph 4 and Graph 5). However, since 2004/05, spending on debit cards has grown more strongly than spending on credit cards. While this reflects many factors, possibly including the reforms implemented by the Bank around that time (see Box A), it is likely mostly a reflection of broader macroeconomic trends, as the period to the mid 2000s was one where the ratio of household debt (especially for housing) to income grew significantly and where the household saving rate was falling. By contrast, the period since the mid 2000s has seen a broad stabilisation in the household debt ratio, a recovery in the saving rate and more conservative trends in card use and debt (as discussed below).

The Bank's 2013 Consumer Use Survey shows that higher-income households use credit cards much more frequently for transactions compared with debit cards; conversely, debit card use is more common for lower-income households (Graph 6). Seventy-three per cent of credit card holders participating in the survey reported that they typically paid off their account in full by the due date each month (within the interest-free period). While this implies that only 27 per cent of cardholders pay interest charges, some industry estimates suggest that a slightly higher proportion (between 30 and 40 per cent) of cardholders pay interest; it is possible that survey responses reflect hoped-for rather than actual behaviour. Subject to this caveat, the survey suggests that the proportion of revolvers is somewhat higher for lower-income households than higher-income ones (Graph 7).

Box A The Reserve Bank's Reforms relating to Payment Cards

Following the 1996–97 Wallis Inquiry, the Reserve Bank was given new powers with respect to the payments system and a new Board, the Payments System Board (PSB), to oversee the exercise of those powers. The Inquiry recommended that the Bank and the Australian Competition and Consumer Commission (ACCC) undertake a review of interchange fee arrangements for credit and debit cards and other aspects of Australia's payments system.

The resulting Joint Study (RBA and ACCC 2000) found that there was very little transparency in the arrangements underlying card payment systems. It found that the card systems, exercising market power, tended to have arrangements that detracted from the efficiency and competitiveness of Australia's payments system:

  • Relative prices to cardholders for card payments in Australia did not generally reflect relative costs. In particular, the resource costs (the cost of ‘producing’ a payment) of a $100 credit card transaction were around 201 cents, but the cardholder usually faced a negative price for this transaction – an interest-free period and reward points to the value of around 90 cents. Meanwhile, the resource costs of a transaction in the domestic debit (i.e. eftpos) system were around 41 cents for that same transaction, but the cardholder faced a positive price of up to 60 cents. The effect of these relative prices was that it was likely that consumers were using credit cards more frequently, and eftpos less frequently, than they would if prices more closely reflected costs. Consequently, the overall cost of making payments was higher than it might otherwise have been.
  • Restrictions on merchants impeded competition and efficiency. Specifically, card schemes had rules that: prohibited merchants from charging more for accepting their cards than for other payment instruments – ‘no-surcharge’ rules; and required merchants to take all cards associated with a particular scheme's brand – ‘honour-all-cards’ rules.
  • Access arrangements for a number of payment systems were more restrictive than necessary to ensure the stability of those systems. In the Bankcard, MasterCard and Visa systems, participation was restricted to authorised deposit-taking institutions (ADIs), and rules discouraged ‘specialist acquirers’ (i.e. firms specialising in providing card acceptance to merchants and not issuing cards to cardholders). In addition, access to the eftpos system was complicated by the bilateral infrastructure and institutional arrangements that applied in the system, meaning that new entrants were required to separately negotiate and establish connections with multiple entities in order to gain effective access.
  • Information on pricing and access in the card systems was not always available. In particular, there was no transparency of interchange fee rates, nor were there publicly available criteria for access for prospective system participants.

Over the early 2000s, the Bank undertook further work and extensive consultation, culminating in a series of reforms. These reforms included measures that changed the prices cardholders faced when using debit and credit cards, reducing the incentives to use higher-cost payment methods. The Bank's reforms also required changes to certain rules in card systems, including enabling merchants to apply surcharges on card transactions so that cardholders were more likely to face prices that reflected the cost of the card they were using. It also took steps that reduced the barriers to entry for entities wishing to issue cards or provide card payment services to merchants.

In 2007–08, the PSB conducted a review of the Bank's reforms. The review concluded that the reforms had improved access, increased transparency and had led to more appropriate price signals to consumers. This review also explored a number of options for possible changes to the regulatory framework, including stepping back from formal regulation and relying on industry undertakings. However, the industry was unable to arrive at suitable undertakings so in August 2009 the PSB decided against stepping back from interchange regulation and noted that the regulatory framework would remain under review.

In March 2015, the Bank commenced a review of the regulatory framework for card payments with the release of an Issues Paper, Review of Card Payments Regulation (RBA 2015a). The review is covering a number of issues including:

  • The decline in transparency for some end users of the card systems, in part due to the increased complexity and the wider range of interchange fee categories.
  • Whether there is scope for interchange fees to fall further, consistent with falls in overall resource costs and as was contemplated in the conclusions to the 2007–08 Review.
  • Widespread perceptions that card surcharges remain excessive in certain industries.
  • Perceptions that the growth of ‘companion card’ arrangements may indicate that the current regulatory system is not fully competitively neutral.

The Bank has received 44 written submissions on the review and has been consulting extensively with stakeholders, via separate meetings and in an industry roundtable that included representatives from 33 organisations including card schemes, card issuers and acquirers, merchants, consumer groups, the ACCC, the Treasury, and staff from Ministers offices. The review is ongoing.

 

The resource costs of credit cards

In 2013–2014, the Reserve Bank conducted a comprehensive review of the costs borne by merchants, financial institutions and individuals in the use of different payment methods (Stewart et al 2014). Drawing on data for 2013, the Payment Costs Study focused on the ‘resource costs’ of the payments system – the economic costs incurred by participants to ‘produce’ payments.

The study found that direct debit payments had the lowest resource costs, while cheques were the most expensive payment instrument (Graph 8).[5] The difference in resource costs across the various payment instruments reflect factors such as processing and authorisation costs, product features, tender time, economies of scale and the average value of transactions. For example, direct debit payments incur fewer resources, reflecting automatic debiting of funds and few manual processing tasks.

Credit card transactions were the most resource-intensive card payment method, with costs of their payment function around 1½ to 2 times the equivalent level for eftpos (and cash) at their typical transaction values. This reflected higher costs borne by both card issuers and acquirers, and a range of costs associated with authorisation and processing of transactions, fraud prevention and payments to card schemes. In addition to the resource cost of providing payment functions, issuers incur significant costs in providing credit and reward functions.

The cost of credit card transactions to cardholders

The Payment Costs Study also provides data on the cost of credit cards and other payment methods to end-users. In the case of consumers, it is useful to distinguish between the average cost of a payment method and the marginal cost for a particular transaction. In addition, it is important to consider the net cost to consumers – that is the costs they pay less any financial benefits they receive in the transaction.[6]

Estimates from the Payment Costs Study suggest that the average net cost to consumers of MasterCard and Visa credit cards was around 19 cents per transaction, where this includes the costs and financial benefits associated with the payments function but not any subsequent interest payments. This compares with costs of around 21 cents for debit card transactions and 13 cents for cash transactions. That is, the net cost to consumers of credit card transactions was around the same as for debit cards and only a little above that for cash, despite the considerably higher overall resource cost of credit cards compared to these other methods. To hold a credit card, consumers typically pay annual and other fees; on average, these fees are equal to around $0.84 per transaction. At the time of the transaction, consumers receive a sizeable inward transfer from financial institutions equivalent to around $0.77 to use the credit card due to the interest-free period and reward points available on credit card transactions. Consumers may also pay a merchant surcharge at the point of sale (of around $0.12 per transaction on average). In terms of incentives at the time of a transaction, the existence of the interest-free period and reward programs means that consumers face a significant incentive to use credit cards over other payment methods.

The rewards programs offered by credit card issuers are due in large part to the existence of interchange fees that are paid by the card acquirer (the merchant's financial institution) to the issuer (the cardholder's bank) in each transaction in four-party card schemes (see Box B). These are then passed on to merchants by acquirers in the form of a higher merchant service fees. In the case of three-party card schemes (such as American Express or Diners Club) there is no direct equivalent to interchange fees, with rewards programs funded directly from merchant service fees charged by the card scheme.

The interchange fee payable on a four-party card transaction depends on the category of that transaction within a schedule of interchange rates set by the scheme. The average level of interchange rates is subject to a Reserve Bank standard that requires that the weighted average of the schedule of rates does not exceed 50 basis points, with compliance required once every three years (or at the time of any reset of the schedule). The specific rate applying to a transaction will depend on the type of merchant (‘strategic’, service station, etc), the type of card (various types of premium cards, corporate, etc) and the nature of the authentication (contactless, SecureCode, etc) or the value of the transaction. There is a hierarchy of categories, which determines how the merchant, card and transaction categories interact. Typically, the relatively low ‘strategic’ interchange rates for large merchants have precedence over the interchange category for the type of card, so that the same relatively low rate for strategic merchants applies for all their transactions, including for those transactions using premium cards with high interchange rates. However, merchants that do not have access to strategic or merchant-specific rates will face different rates based on the type of card presented.

In recent years, there has been significant growth in the premium segment of the credit card market, with the emergence of ‘super-premium’ and, more recently ‘elite’/‘high net worth’ credit cards in addition to ‘gold’ and ‘platinum’ cards. Issuing banks can earn higher interchange fee revenue on these products than from standard credit cards, and may use this revenue to fund more generous rewards programs in terms of frequent flyer points, spending vouchers at retailers, travel insurance, etc. One objective measure of the generosity of rewards to consumers is in terms of the card spending required to generate a $100 voucher, which can be translated into an effective cash-back percentage. Data on the interchange rates and rewards on offer in a sample of around 80 cards monitored by the Bank, show a positive correlation between the interchange rate on cards and the generosity of rewards by issuers (Graph 9).

Box B Interchange Fees

An interchange fee is a fee charged by the financial institution on one side of a payment transaction to the financial institution on the other side of the transaction. They are most commonly seen in card transactions, although can arise in other payment methods.[7]

A typical card transaction (Figure 1) involves four parties – the cardholder, the cardholder's financial institution (the issuer), the merchant and the merchant's financial institution (the acquirer). For most card transactions, the interchange fee is paid by the acquirer to the issuer. Interchange fees can have important implications for the prevalence and acceptance of different cards as well as the relative costs faced by consumers and merchants. In contrast to normal markets for goods and services, competition in payment card networks can actually drive fees higher.

Financial institutions typically charge fees to their customers for payment services. Cardholders are charged by their financial institution in a variety of ways. In the case of payments from a deposit account such as debit cards, financial institutions typically charge a monthly account-keeping fee and, sometimes, a fee per transaction (or for transactions above a certain number). In the case of payments using a credit card, financial institutions usually charge an annual fee rather than a per transaction fee, and interest is charged on borrowings that are not repaid by a specified due date.

Merchants receiving payments are also typically charged by their financial institutions. The fees paid by merchants usually depend on the payment method. For credit and debit cards, merchants are usually charged a ‘merchant service fee’ for every card payment they accept. Some merchants are also charged a fee by their financial institution to rent a terminal to accept cards.

In contrast, interchange fees are paid between financial institutions and are present in many, but not all, card systems.[8] Interchange fees are often not transparent; cardholders and merchants do not typically see them. But they have an impact on the fees that cardholders and merchants pay.

In the MasterCard and Visa credit card schemes, interchange fees are paid by the merchant's financial institution to the cardholder's financial institution every time a payment is made using a MasterCard or Visa card. This has two effects. First, the merchant's financial institution will charge the merchant for the cost of providing it with the acceptance service plus the fee that it must pay to the card issuer (the interchange fee). The higher the interchange fee that the merchant's financial institution must pay, the more the merchant will have to pay to accept a card payment. Second, since the card issuer is receiving a fee from the merchant's financial institution every time its card is used, it does not need to charge its customer – the cardholder – as much. The higher the interchange fee, therefore, the less the cardholder has to pay. In effect, the merchant is meeting some of the card issuer's costs which can then be used to subsidise the cardholder. Indeed, with rewards programs, the cardholder may actually be paid to use his/her card for transactions.

Where the market structure is such that there are two payment networks whose cards are accepted very widely (i.e. merchants accept cards from both networks), and where consumers may hold one network's card but not necessarily both, competition tends to involve offering incentives for a consumer to hold and use a particular network's cards (loyalty or rewards programs, typically). A network that increases the interchange fee paid by the merchant's bank to the cardholder's bank enables the cardholder's bank to pay more generous incentives, and can increase use of its cards. However, the competitive response from the other network is to increase the interchange rates applicable to its cards.

In the early 2000s, the Reserve Bank became concerned that credit card holders were effectively being subsidised to use their credit cards through arrangements that added to merchants’ costs. Interchange fee revenue allowed card issuers to support generous credit card rewards programs and, as a result, many credit card holders were facing a negative effective price for credit card transactions, even though those cards had positive costs for the system as a whole. This distorted price signals to cardholders about the relative costs of using different payment instruments.

The Reserve Bank therefore introduced a number of reforms to the credit card market from 2003, with the aim of improving efficiency and competition in the Australian card payments system. Among other things, the reforms reduced interchange fees, which had been used by card issuers to support attractive rewards programs on credit card products. Overall, reward points and other benefits earned from spending on credit cards have become less generous, although card schemes have found ways, within the bounds of the Reserve Bank's regulation, to increase incentives for card issuers to promote particular products within their suite of offerings. Over time, MasterCard and Visa have progressively introduced new, higher fee categories for consumer and business cardholders, based on the type of card held (e.g. premium/platinum, super premium, ‘elite’/‘high net worth’). This enables issuers to pay more generous incentives to holders of these cards; card issuers have responded, particularly through new strategies focusing on the premium segment of the market.

The cost of credit cards to merchants

As recognised by the Terms of Reference, interchange payments (and the loyalty programs they finance) increase the costs of payments for merchants and accordingly drive up the final prices of goods and services for all consumers, including for consumers who do not use credit cards.

The interchange schedules for the MasterCard and Visa credit card systems include a wide range of interchange rates from 0.20 per cent or 0.23 per cent for some ‘strategic’ large merchants to 2 per cent for the highest level of premium cards (Table 1). Based on the hierarchy of interchange rates, the cost of the high interchange rates on premium or commercial cards falls entirely on small merchants and other merchants that do not benefit from special rates.

There are two significant consequences of the current structure of interchange schedules. First, there are now large differences in the average interchange rates paid on the transactions of strategic or qualifying merchants compared with other merchants. The Bank estimates that the average credit card interchange rate for non-preferred merchants (i.e. those not benefiting from strategic or other preferential rates) was more than 50 basis points higher than the interchange rate applying to preferred merchants in the December quarter of 2014. These differences in interchange rates have a corresponding effect on the merchant service fees faced by the two groups which is in addition to the higher margin that acquiring banks would normally apply to small merchants relative to large merchants. The second consequence of the complex interchange fee schedules is that the non-preferred merchants have little transparency over the cost of particular transactions. In the case of a MasterCard or Visa credit card transaction, the interchange rate will be 30 basis points on a standard card but will be 200 basis points if the transaction involves the highest level of premium card. In contrast, for strategic merchants the cost of all cards issued in Australia, from standard non-rewards cards to the highest level of premium cards, will be constant (and as low as 0.20 per cent).

The Bank collects data on average merchant service fees for the different payment schemes (Graph 10). For the June quarter 2015, merchant service fees were around 2.1 per cent for Diners Club, 1.7 per cent for American Express, and 0.79 per cent for MasterCard and Visa, though the latter also includes debit card merchant service fees. The Bank estimates that merchant service fees for MasterCard and Visa credit cards were around 0.87 per cent in the June quarter.

Merchants have some ability to recoup the costs of more expensive payment methods via the use of surcharging for such payments. While the majority of merchants do not surcharge for particular payment methods, the right to surcharge is important to promote efficiency in the payments system and is also a means by which merchants can exert some downward pressure on the cost of payments. There are, however, some instances of firms in particular industries which may be surcharging excessively for some customers; the Bank is currently consulting on this issue as part of its review of the regulatory framework for cards payments.

Footnotes

While credit cards can also provide cash withdrawals, their use for this has been falling since 2007/08; cash withdrawals are around 25 per cent lower than in 2007/08 and now account for 3¼ per cent of all credit card transactions. Most of the data cited in this submission are for transactions, excluding cash withdrawals. [4]

All costs from the study are at the average transaction value for each payment instrument. [5]

The incentives discussed here ignore some of the potential benefits for credit card holders and consumers of different payment methods. For example, card payments may provide consumers with the benefit of a greater feeling of security as they reduce the need to carry large cash holdings; on the other hand, some consumers report in surveys that they prefer the budgeting discipline that cash or debit cards bring relative to credit cards. [6]

There is now a substantial theoretical literature on the role of interchange fees in card systems; see Verdier (2011) for a recent survey. [7]

For example, the European Commission (2013) notes (p 53) that ‘in Norway, the absence of IFs [interchange fees] for debit cards is accompanied by very high level of card acceptance by merchants and usage. Denmark also has one of the highest card usage rates in the EU at 216 transactions per capita with a zero-MIF [multilateral interchange fee] debit scheme. This is also true of international schemes: in Switzerland Maestro has no MIF and is the main debit card system. It is also worth noting that all European card schemes were originally created without MIFs. MIFs have been introduced by banks and card schemes only later.’ [8]