Are Card Companies Reverse Robin Hoods?

The New York Times is running a series on various forms of payment cards, and a re-occurring theme appears to be whether card companies effectively rob the poor to reward the rich. Are they Reverse Robin Hoods. Last Friday, Floyd Norris's High & Low Finance column claimed that low income consumers actually pay more than the affluent. He reached this conclusion by reasoning that merchants charge everyone the same price, but that those who carry reward credit and debit cards get a rebate from their card companies. The less affluent who pay in cash thus effectively pay more. I have argued elsewhere that Norris's analysis is too simple and may well be wrong. On today's front page, however, Times reporter Andrew Martin has a story entitled "Prepaid, but Not Prepared for Debit Car Fees" that shows that the situation for the poor may be even worse. This piece argues that pre-paid debit cards -- used by many low income people who lack bank accounts -- charge outrageous fees. These cards are a relatively new product not addressed in the recent credit card legislation or bills addressing traditional debit cards linked to checking accounts. One has to wonder why a pre-paid product should trigger high fees given that the issuer is bearing no credit risk or the administrative costs of billing the cardholder.

These articles, of course, raise more questions than they answer. Is it really true that merchants could lower their prices if they stopped accepting credit cards? If so, why don't we see more merchants doing it. Wouldn't the lower prices they could charge give them a competitive advantage? If not, what is it about the payment card market that seems immune to many forms of competition? For example, why would low income consumers waste money on a pre-paid debit card when they could open a bank account with lower fees? Banks seem to be responding to threatened debit card legislation, and American Express has taken a competitive stance on gift card fees, apparently spurred by recent credit card legislation. Shouldn't market pressures produce competition without actual or threatened legislation? In future posts, I'll try to explore some of these questions and consider ways in which the law might help advance consumer interests.

Big Banks Alter Debit Overcharge Rules

Presumably trying to get out in front of proposed legislation that would require banks to ask their customers if they want to "opt in" to debit card overdraft protection, JP Morgan Chase and Bank of American recently announced that they would be altering their overdraft policies. Both banks will stop charging overdraft fees for very small amounts (less than $5 for Chase and $10 for BofA) and will soon provide their customers with the option to opt out of overdraft protection so that a purchase would not be authorized if it would put the cardholder into an overdraft position. Both banks also plan to limit the number of overdraft charges that may be imposed in a single day, and Chase will also drop a controversial method of calculating overdrafts.

According to the N.Y. Times, both banks described their actions as responsive to their customers. “We made the decision that we had to help customers now and help those most stretched by the economy,” said Brian T. Moynihan, president of Bank of America’s consumer and small-business banking operations. “They found themselves getting hit by too many fees, and they said, ‘Help us out.’ ” There is little doubt, however, that threatened legislation has played a role. According to Michael Moebs, an economic advisor for many banks and credit unions, the banks understandably oppose this legislation because many of them collect more in overdraft fees than they earn in profits. Moebs argues that many banks would not be able to replace the revenue soon enough to stay in business.

So, have Chase and BofA, done enough to forestall legislation? While the changes they plan to implement are certainly a step in the right direction, they hardly eliminate many concerns.

For example, the exception for small overdrafts may only protect the cardholder if they deposit sufficient funds to cover the overdraft before making additional charges. But if the cardholder is not notified of the overdraft situation, how often will that happen?

The limits on the number of overdraft fees also hardly eliminate the seeming unconscionability of the arrangement. As an initial matter, they will apply only to purchase at stores, not ATM withdrawals. Second, the amount of fees will continue to bear no reasonable relationship to amount of the overdraft. Bank of America is limiting its cards to no more than four overdraft fees per day. But the fee remains $35 per overcharge, regardless of the amount. So, a customer that makes four purchases over the limit that total just $11 or $12 dollars would pay $140 in fees. The result at Chase is only marginally better. It will impose a limit of three fees per day, but they would total $89 on three overcharges that could amount to as little as $5.01. As Brad Tuttle wrote on the Time website, "[s]o the poor saps who are dumb enough to spend more than they have in their accounts—and who do so more than three or four times a day—are thrown a bone." I would add, a very small bone at that.

I have not seen any justification for these fee levels. Surely, a bank providing overdraft protection should be entitled to a reasonable return on the money it effectively lends to its customer as well as a reimbursement for the incremental administrative fees it incurs because a charge results in an overdraft. These fees appear to exceed the bounds of reason by several orders of magnitude. And surely, the banks would produce the data necessary to justify them if it existed.

Even the proposed new opt out provisions are less than they seem. They will require the customer to forgo overdraft protection for check writing as well as debit card use, a risky proposition given that many vendors charge their own penalty fees for bounced checks.

One doubts that these steps will satisfy the concerns of those in Congress who have proposed legislation to limit overdraft fees.

NY Times Takes on Debit Card Overdraft Fees

Was it a coincidence that the same day the first of the new credit card regulations went into effect, the N.Y. Times lead editorial called out the banks for charging high overdraft fees, one of the same issues addressed in the new credit card legislation? (For those unfamiliar with the Credit Card Act here's a guide.) Probably not. This issue has been banging around for more than two years. Several sources have published horror stories in recent weeks about banks permiting customers to compete transactions with debit cards and then imposing overdraft fees that are grossly disproportionate to the overage. It is bad enough to be charged a $25 fee for going over ones credit limit when making a $200 credit card purchase. But a $35 fee for a $2 cup of coffee bought with a debit card somehow seems even more offensive. The Times described a college student who bought $16.55 in school supplies and coffee through several separate debit card purchases and was charged over $200 in fees. Another report described a $35 overdraft fee when a store made an 8 cent adjustment to a prior charge after an account had been closed. The new credit card act requires that cardholders opt in to any system paying over the limit charges while imposing a fee and limits over-the-limit fees to one per billing cycle. Consumer groups have argued that the same opt-in procedures should be required for both credit and debit. The N.Y. Times argues that banks should be required to develop the technology to allow consumers to choose whether to overdraft their accounts on a purchase by purchase basis.

The Credit Card Fair Fee Bill is Back

Having tackled the cardholder side of the credit card business last month by enacting the Credit Card Holders Bill of Rights, Congress has gone back to its other piece of unfinished card legislation, the Fair Fee Act. This bill deals with the fees that merchants pay to accept credit cards.

Last August, the House Judiciary Committee approved a version of this bill, but like the consumer-oriented bill of rights, the merchant-fee legislation got lost in the financial crisis shuffle. It is now front and certain again. Inexplicably to me, however, the new version, like last year's, advances the notion that credit card merchant fees can be controlled by giving merchants a "seat at the table" and putting a Department of Justice, Antitrust Division, lawyer there as well. I am quite skeptical about whether this approach would be successful. To be sure, merchants complain that inter-change fees are currently non-negotiable. They are presented to merchants by the Visa and MasterCard systems on a take it or leave it basis. Of course, merchants have always been free to "leave it," and the card systems have had to take that possibility into account in setting the fees. Giving the merchants a seat at the table will not change the dynamic. The merchants sole bargaining chip will remain the right to refuse to accept the card. But if card systems know now that merchants cannot say no, it is hard to image how merchants will be able to convince them otherwise just because they have a seat at the table.

The legislation does provide for antitrust immunity to both card issuers and merchants that negotiate collectively. It would thereby bless the long standing practice of issuers in the Visa and MasterCard systems of collectively imposing their merchant fees. For someone who believes as I do that the remedy for anticompetitive interchange fees is more competition, explicitly permitting collective fee setting seems like a very bad idea. And for the merchants' part, although collective negotiations might enable them to more credibly threaten not to accept a particular card brand, the legislation exempts group boycotts from the scope of the antitrust immunity. Would a group of merchants in a negotiation under the proposed act engage in an unlawful group boycott if they collectively threatened to stop accepting Visa? The legislation does not make this clear, but it is hard to see how such a collective threat would not constitute a boycott.

Another way in which the legislation might be thought to help merchants is that it mandates that all merchants participating in a negotiation are entitled to the same fee rate regardless of the merchant category in which the card system had previously placed those merchants. One might image a negotiation including Walmart and many smaller retailers in which the small retailers would end up with the same rate as Walmart. But what incentive would Walmart have to join such a negotiation? Walmart already has enough clout to force the card systems to give it a reduced fee, and that fee constitutes a competitive advantage over other retailers that Walmart would be loath to give up.

The legislation originally proposed by Congressman Conyers in the spring 2008 would have set up an interchange court to set fees if the merchant/card system negotiation reached an impasse. The fee court was stripped from the legislation passed by the House Committee last summer to attract sufficient votes for committee passage, and it has remained out of the House bill that Conyers introduced in early June.

Senator Durbin, however, has now introduced a new Senate Bill that brings back the idea of a fee court to set interchange fees when merchants and card systems fail to agree. The process would resemble an arbitration proceeding before a panel of judges appointed by antitrust enforcers at the DOJ and FTC. If the merchants and card systems could not reach agreement, a hearing would be held at which both sides could present evidence and argument about a fair fee level. The panel would then set the fee, which would remain fixed for three years.

One could reasonably oppose the fee court on at least two grounds. First, the court would have insufficient information and expertise to set appropriate fees, and second, it would likely be subject to undue influence by the regulated parties just like the rate setting bodies of old. But at least the threat of an imposed fee might lead the card systems to try to reach agreement with the merchants.

The bill is likely to face fierce lobbying opposition from card systems and issuers, large and small. Credit Union National Association Senior Vice President of Legislative Affairs John Magill summed up the issuers argument this way: "The merchants' effort to avoid paying their fair share of electronic transactions threatens the integrity of the payment processing system."

I continue to wonder why Congress does not simply require the largest card issuers to negotiate their own interchange fees. That is, force Citi, Chase, Capital One, and a few of the other large issuers to set their own fees. Merchants could then much more credibly threaten to drop a card, because they could single out one issuer as opposed to dropping out of Visa or MasterCard, entirely. To be sure, this approach would differentiate among issuers by allowing some to set fees collectively through Visa and MasterCard, while others would have to compete individually. But the discrimination makes sense in that the large issuers create the market power in Visa and MasterCard that has allowed them to increase merchant fees so dramatically in the past. If the largest issuers were stripped out, Visa and MasterCard could continue to set merchant fees for their many small issuers without the sort of anticompetitive clout that they now wield. Moreover, the House Bill exempts small issuers from the mandatory negotiation proceedings, thus recognizing that it is appropriate to treat small and large card issuers differently.

Obama Signs Credit Card Holders Bill of Rights

After years of legislative wrangling, President Obama has signed a credit cardholders' bill of rights that was passed overwhelmingly by both houses. Last September, the House passed a similar bill that died in the Senate. Last December, the Federal Reserve issued a series of regulations that would have imposed many of the requirements in the new legislation, but not until January or July 2010, depending on the provision. The heightened recent legislative activity had been attributed to a desire to trigger the Federal Reserve regulations more quickly. The final bill, however, calls for implementation 12 months from enactment, meaning that the rules will go into effect only about 1 month sooner than the FED's regulations. The legislation, however, goes beyond the regs in some areas. This post provides a summary of the key points in the legislation. I'll summarize the comments and reaction, and speculate about the effects, in a future post.

Summary of Key Provisions:

Notice: Requires card issuers to provide at least 45 days notice prior to any rate increases or other significant changes, and the notice must include a statement that the cardholder may cancel the card.

Increasing Interest Rates on Outstanding Balances: Limits the ability to increase the interest rate on existing balances to specific situations, including a failure to make the minimum payment for 60 days.

Double Cycling Billing: Prohibits reaching back and assessing interest on balances from the prior billing cycle if the cardholder fails to pay the balance in full. Average daily balance accounting, in which interest is assessed to the entire balance, rather than just the portion left unpaid, is not prohibited.

Allocation of Payment: requires that any payment beyond the minimum be allocated first to debt accruing the highest rate of interest. This provision is substantially tougher than the FED regulation, which would have allowed the banks to allocate payments proportionally among balances of varying interest rates.

Timely Payment: Requires statements to be issue 21 days before the due date, and prohibits assessing late fees when the due date is a day on which mail is not delivered (or not accepted) and the payment is received by mail the next business day.

Over-the-Limit Fees: Requires that the cardholder opt-in to a system in which charges over the limit are permitted with a late fee and limits these fees to once per billing cycle. This provision is also more consumer friendly than the FED regulations, which had left open the possibility of an opt-out scheme.

Minors & College Students: Prohibits the issuance of credit cards to unemancipated minors, unless a parent is designated as the primary account holder, and places strict limits tied to annual income on the credit limit for cards issued to college students.

Means-of-Payment Fees: Prohibits fees for using non-standard payment methods, except for expedited payments by phone on the due date or the proceeding day.

Warning: Requires solicitations to provide a warning of the adverse effects of excessive credit inquiries.

Contesting Arbitration Clauses in Credit Card Agreements

Cardholder credit card agreements typically include an arbitration provision requiring that “[a]ny dispute, claim, or controversy ... arising out of or relating to relating to this Agreement” be settled in an arbitral, not a judicial, forum. These provisions have been under attack in two on-going antitrust conspiracy cases before Judge Pauley in the Southern District of New York. In the first case, the plaintiffs alleged that Visa, MasterCard, American Express and several large credit card issuers, conspired to inflate foreign currency transaction fees. (Visa, MasterCard and the issuer defendants have reached an agreement in principle to settle the case that is currently being reviewed by the court.) Although the plaintiffs are not American Express cardholders, AmEx has argued that they should be bound nonetheless by the arbitration provisions in their cardholder agreements. The plaintiffs should not be permitted to circumvent their arbitration agreements, AmEx claims, by joining an outside party to a conspiracy claim.

Judge Pauley agreed with AmEx on that point, finding that principles of equitable estoppel prohibited the plaintiffs from refusing to arbitrate. The court further recognized, however, that the arbitration agreements might nonetheless be unenforceable as a product of the antitrust conspiracy. It ordered a trial on the validity of the agreements before reaching a final decision on whether the plaintiffs could be compelled to arbitrate.

The plaintiffs appealed, and the Second Circuit reversed. Recognizing that a non-party to an arbitration agreement may in some cases rely on principles of collateral estoppel to compel arbitration, the court held that a more significant connection between the parties was required than AmEx could show with the plaintiffs. For example, the Second Circuit pointed to cases dealing with corporate affiliates or others with whom the plaintiff had interacted directly. Since the plaintiffs were not American Express cardholders, and they had no reason to anticipate any direct interaction with AmEx when they entered their cardholder agreements, the plaintiffs could not be compelled to arbitrate. Ross v. American Exp. Co. --- F.3d ----, 2008 WL 4630314 (2nd Cir. 2008).

In the second case, cardholder plaintiffs allege that card issuers have violated the antitrust laws by agreeing to include arbitration provisions in all of their cardholder agreements. Judge Pauley initially dismissed the suit for lack of standing, reasoning that any injury would be contingent on future disputes that cardholders might be forced to arbitrate. Again, however, the Second Circuit reversed, holding that an agreement not to compete on a critical contract provision deprived the plaintiffs of a meaningful choice and thus resulted in injury in fact.

Discover now argues that the claim against it should be dismissed because its arbitration provision permits cardholders to opt out within 30 days. The plaintiffs have responded that the opt out provision is inadequate because it places too high of a burden on cardholders. The court is currently considering Discover’s motion. Ross v. Bank of America, N.A., 524 F.3d 217 (2nd Cir 2008).

Credit Card Holders Bill of Rights

In the midst of all the bailout activity, the House passed the Credit Cardholders' Bill of Rights Act of 2008 with virtually unanimous support from Democrats and 84 Republican votes. Although passage of the bill in the Senate was always iffy, and is now extremely unlikely, the new Congress is likely to revisit these issues.

The "Bill of Rights" title might lead one to think that the bill incorporated a short list of broad principles. In fact, it addresses a number of specific issues in a particularized and technical way. What follows is a summary of the main provisions:

1. Card issuers would be prohibited from increasing the interest rate on existing balances, unless (a) the rate is tied to a publicly available index that is not under the issuer's control; (b) the increase is the result of (i) the expiration or loss of a promotion rate for a reason that was disclosed in an account agreement; or (ii) the cardholder's failure to make the minimum payment more than 30 days past the due date.

2. Issuers would be required to permit cardholders with existing balances at the time of a rate increase to amortize the existing balance over at least a 5-year period and the percentage of the existing balance that was included in the required minimum payment cannot be more than doubled.

3. Rate increases would require 45 days notice, must be complete and conspicuous, and explain the extent to which they apply to an existing balance.

4. Double cycle billing would be prohibited.

5. Where a cardholder fully pays a balance and only interest accrues during the billing period, the bill would prohibit (a) any fee in connection with the interest-only balance and (b) the issuer from treating a failure to make timely payment as a default. The cardholder would remain responsible for paying the interest.

6. Issuers would be prohibited from furnishing information to a consumer reporting agency until the card is used or activated, except that the issuer may furnish information about any application for a credit card account.

7. Issuers would be required to treat any payment received, or transferred by wire over a web-based or telephone system, by 5PM on the due date as timely. A receipt showing that the payment was mailed not less than 7 days before the due date would also constitute presumptive payment by the due date, unless the issue shows fraud or dishonesty on the part of the cardholder with respect to the mailing date.

8. Where an account has multiple interest rates, the bill would require that the issuer allocate payment among the outstanding balances in the same proportion as each such balance bears to the total outstanding balance. Issuers would be permitted to allocate a higher percentage to higher interest rate balances, but they would be prohibited from engaging in the now common practice of allocating the entire payment to the lowest rate balance.

9. If an account includes a grace period, cardholders taking advantage of promotional offers could not be denied the benefit of the grace period.

10. Issuers would be required to offer cardholders the option to elect not to permit the bank to authorize an over-the-limit charge and thereby avoid fees for going over the limit. Issuers would be permitted to authorize charges going over the limit by a small amount, but they could not charge a fee.

11. Over-the-limit fees could be charged only once during a billing cycle.

12. Additional information would be collected on rates and fees.

13. Issuers would be prohibited from financing up front fees in excess of 25% of the credit authorized on the account.

14. Credit cards could not be issued to anyone under 18 unless emancipated under state law. A signed application indicating that the applicant is 18 would protect the issuer.

The provisions in the bill resemble those proposed by the FED last May, which have generated a record 56,000 comments. Some opponents of the bill, including the White House, contend that regulators are better equipped to deal with these sorts of issues. Proponents contended that controls on the credit card industry require the force of legislation.
The industry, not surprisingly, came out strongly against the bill. A statement from the American Bankers Association argued that the provisions in the bill would limit the banks ability to manage risk and therefore raise prices and restrict the availability of credit to consumers and businesses.

The bill would not address the issue of merchant credit card acceptance fees that are currently being challenged in a nationwide class action. In August, the House Judiciary Committee reported a bill dealing with merchant fees, and the new Congress is likely to take up that issue.

Credit Card Fair Fee Act

Update: The final amended language of the Credit Card Fair Fee Act, as reported by the House Judiciary Committee, is now available. It employs a rather clever two-step device in an attempt to stimulate negotiated merchant fees. First, as blogged below, the bill extends antitrust immunity to groups of merchants and banks negotiating card acceptance fees. But then, it pulls the immunity back whenever a card issuer, or acquirer, or a merchant “is engaged in any unlawful boycott.”

Could this language mean that neither the merchant group, nor the banks, can walk away from the negotiations if the other side does not agree to acceptable terms? The take-it-or-leave-it approach has long been the banks’ modus operandi. Taking this threat from their arsenal could meaningfully change the market dynamic. Still, one has to wonder how a negotiation is supposed to proceed if the parties can’t threaten to walk away.

The bill would require the largest merchants, card issuers, and acquirers to produce cost information to the DOJ Antitrust Division, and Division representatives would take part in the negotiations. All this seems to stack the deck in favor of some sort of cost-based, negotiated merchant fee, which would be fine if costs served as a basis for setting an efficient fee. Unfortunately, they don’t; as the economist Michael Katz has explained.

A competitive means to set merchant fees would likely be superior to a cost-based system. There are at least three proposals in the literature to set fees competitively: (1) placing the costs of payment mechanisms on consumers by, for example, allowing merchants to surcharge card transactions; (2) empowering merchants to select the network over which a payment will be processed; and (3) forcing large card issuers to negotiate their own interchange fees. I have advocated for the latter, but all three seem to hold more promise that the Judiciary Committee’s current approach.

Original Blog: On July 16, the House Judiciary Committee reported out Congressman Conyers’ Credit Card Fair Fee Act over a sharply divided, yet surprisingly non-partisan, 19-16 vote. The amended text is not yet available, but you can piece it together from the hearing transcript at http://judiciary.house.gov/hearings/transcripts/transcript080716.pdf.

The bill as reported differed significantly from the bill originally introduced in March. Both bills are intended to combat the problem that merchants need to accept Visa and MasterCard so desperately that they have little ability to resist fee increases. At the heart of both the original March bill and the amended bill is essentially a bargaining order, requiring the banks issuing cards on large systems to negotiate with merchant groups on interchange fees and exempting from antitrust scrutiny the agreements reached in these negotiations. A key provision of the original bill would have created a panel of interchange fee judges, who would have set the fees if the parties could not agree. The Department of Justice and Federal Trade Commission both opposed the bill and were particularly critical of the panel of judges. At the July 16 hearing, Congressman Conyers removed the panel proposal from the bill. In addition, he added provisions (1) permitting small banks and credit unions to exempt themselves from these negotiations and (2) requiring that merchants do not simply retain fee reductions as profit.

This bill fails to engage the real problem with interchange fees, because a bargaining order is unlikely to reduce the card systems’ market power. Removing the judicial panel means that there is no real threat if the card companies fail to engage in meaningful bargaining. Still, eliminating the panel was a wise decision. Efficient interchange fee setting cannot track costs or any other factor accessible to a panel of experts. Appropriate fee setting must take account of demand conditions that are simply inaccessible to a regulator and probably the market participants as well. Given that, there seems to be little reason to provide an antitrust exemption. Who knows what mischief these bargaining groups might get themselves into?

The remedy to the interchange problem will ultimately be competitive, not regulatory. Congress could bring this about by simply requiring the large card-issuing banks to set their own interchange fees. If Discover can set an independent merchant fee with a market share of 5-6% of transaction volume, Citibank, Chase, Bank of America, CapitalOne, and perhaps a handful of others should be able to do so as well. Merchants would have substantially more leverage if they could refuse one issuer’s cards as opposed to the entire Visa or MasterCard association. Congress could achieve this result by simply prohibiting the card systems from enforcing the aspect of their honor-all-cards rule that requires merchants to accept the cards of every issuer on the network. Traditionally, this sort of remedy has been opposed as unworkable. After all, there are thousands of issuing banks. Requiring all of them to set their own fees, many have claimed, would be a mess. One positive aspect of Fair Fee bill is that it apparently recognizes that the rules that apply to the big issuers should not necessarily apply to smaller players. The bill applies only to systems with more than 20% of card volume and permits small banks and credit unions to exempt themselves from the negotiations. A competitive bill might require only those issuers with more than 5% of card volume to set their own fees. Without the large issuers in the mix, Visa and MasterCard could continue to set interchange fees for their thousands of smaller issuers without the power to compel merchant acceptance that has led to excessively high fees.

Credit Card Fee Regulation: Could Disclosures Stimulate Competition?

Taking a break from blogging about merchant fees, this week’s post looks at the current debate with respect to credit card regulation. Although some in Congress have been thinking about merchant fee regulation, the hot action currently seems to be on the cardholder fee side.

For the last several months, Congress has been kicking around whether new regulation should prohibit certain practices or simply mandate more effective disclosure. Senator Ron Wyden is pushing the disclosure angle through an interesting star rating system, while Senator Carl Levine, among others, favors prohibitions. In May, the Federal Reserve proposed regulations aimed at some of the same concerns, and this weekend, a New York Times article indicated that the tide seems to be turning away from disclosure and in favor of direct regulation. Although a number of practices pop up in the various bills and regulations – mandatory arbitration provisions; charging interest on debit paid within the grace period; over-the-limit fees for approved transactions; fees for paying the bill by phone – every proposal takes aim at the practice of first allocating payments to lower interest rate debt.

I agree that this practice can be particularly egregious. A card company can lure a consumer into transferring a large balance with the promise of a low interest rate while charging “transaction fees” on the balance transfer that will be subject to interest. A consumer who spots the transaction fee may miss that the deal includes a relatively high interest rate on all new purchases. Even the wily consumer who catches both the transaction fee and the high rate on new purchases may mistakenly assume that she can simply pay off her new purchases within the grace period, avoiding interest. If the card company allocates payments first to the low interest balance transfer, however, the account will accrue interest at the high new purchases rate until the entire old transferred balance is completely paid off. Even if the cardholder paid more than the sum of the minimum payment on the balance transfer and the cost of all new purchases for that month, interest would begin accruing on the new purchases because the entire payment would be allocated to the low interest balance transfer. Yikes, by the time the old balance is paid off, the cardholder is likely to have a new one that is just as large and probably at a higher interest rate. Would you have caught all that? I admit, I’ve been caught a few times, and I’ve been studying credit card offers for over a decade.

One can debate how well the various proposals would actually protect consumers given the flexibility that card companies have in structuring their offers. Ironically, a disclosure requirement could be more effective in combating the payment allocation concern. Some may argue that card companies already disclose transaction fees and the allocation of payments among varying interest rate debt. Of course, the current methods of disjointed, fine print disclosure leave consumers who are not financially sophisticated unable to understand the terms of their agreement.

What’s needed is a disclosure along the lines of those provided by mutual fund companies. Those companies provide a return and fee breakdown based on a hypothetical investment. Credit card companies should be required to do the same. They should disclose all of the charges that they would assess on a hypothetical balance transfer and new purchase balance of, say, $1000 each. In addition to interest charges, the card company should be required to include all transaction fees and other fees that a cardholder might be expected to pay over the course of a year. For example, if the average cardholder pays one late or over-the-limit fee annually, that fee should be included. If the card company offers a reward or rebate, it could incorporate that into the disclosure as well. Most importantly, in type as large as the largest on the mailing or other offer, the card companies should be required to disclose the effective net interest rate – calculated pursuant to a formula developed by Congress or the Federal Reserve – that a typical cardholder would pay if the hypothetical balances were maintained for a year.

By mandating this sort of disclosure, even unsophisticated consumers would be able meaningfully to compare offers from various issuers. The comparison would be nearly as simple as comparing differing annual fees. The resulting competition might well protect consumers more effectively than prohibiting any particular practice.

Butchering Credit Cards

In my last post, I explained that all credit card systems in the United States charge merchants a fee above marginal cost and that the systems use this revenue to stimulate card use. The Visa and MasterCard systems call this increment above cost their interchange fees, but all systems effectively do the same thing. At first blush, this sort of above cost pricing suggests serious antitrust concern. Aren’t card systems extracting supra-competitive profits from merchants? And even if they compete these profits away simulating card use, doesn’t overcharging merchants distort resource allocations? This post explains why the answers may be no.
In a typical market in which a producer competes for a single type of customer, an efficient price – one that will lead to an optimal consumption level – will generally approximate the marginal cost of production plus the profit necessary to attract investment to the industry. This pricing model is efficient because it maximizes short-run output consistently with the producer earning sufficient revenue to continue providing the product or service.
Credit card markets are not typical, however, in that card systems must price their products in a way that appeals to two inter-related sets of customers, merchants and cardholders. In such a two-sided market, a purely cost-based rule – such as “set the price charged to the cost-causer at marginal cost” – is unlikely to produce an optimal pricing structure. Although the economic literature is riddled with papers written by consultants for the card systems – not that there’s anything wrong with that – economists on all sides generally agree on this basic point. Compare Meg Guerin-Calvert and Janusz Ordover’s analysis with Michael Katz’s take, from which I quote above.
In a two-sided market, efficient pricing must take account of both total cost and the relative elasticities of demand between the two customer sets. If customers in such a market were charged the marginal cost of serving them, they would fail to internalize the benefits of their decisions to the customer set on the other side. If demand elasticities diverge to any significant degree, industry output under a marginal-cost pricing policy would be inefficiently low. To obtain an efficient output level, a producer must charge the customer set that is more sensitive to price less than marginal cost (effectively enabling those consumers to internalize the benefits to both sides of the market).
The classic example is the daily newspaper. Readers have many sources of news, including television, magazines, and the internet. Reader demand for newspapers is thus likely to be quite elastic, leading them to turn away from the morning paper if the subscription price were to approach the marginal cost of producing and delivering it. By contrast, advertisers perceive significant benefits in print advertising (so long as readership is high) and are thus willing to pay substantially above the newspapers’ marginal cost of printing and providing associated services. As a result, readers pay significantly below marginal cost and advertisers pay substantially more. Competition between newspapers and other media for advertising space still drives pricing, but not to marginal cost plus normal profit for each customer set.
This pricing pattern efficiently optimizes newspaper circulation, satisfying both the advertisers’ need for broad exposure and the readers’ need for information. Assuming that newspapers have little market power, both advertisers and readers would be worse off if pricing were forced into line with marginal cost. Were advertising fees to drop, and reader fees proportionally increased, prices would move toward marginal cost on each side of the market. Because reader demand is more elastic, however, readership would drop more than advertising would increase, and advertising rates would thus fall. As a result, the paper would (1) earn lower overall revenue; (2) be less valuable to advertisers because readership would fall; and (3) be less valuable to readers because the paper would have less revenue for newsgathering.
To the extent that the elasticity of demand varies significantly between merchants and cardholders, credit systems resemble newspapers. Assuming that merchants, like print advertisers, are willing to pay significantly above the marginal cost of credit card acceptance services, but cardholders, like newspaper readers, would be unwilling to pay the marginal cost of providing credit cards and associated services, then efficient credit card pricing should place a greater share of the costs on merchants.
One might question whether this analysis explains the array of interchange fees that the card systems now charge. Even if efficient pricing requires merchants to pay more, why should they pay more still for reward cards used primarily by wealthy customers who would arguably make roughly the same purchasing decisions with a simple basic credit card? The answer may be that price discrimination can result in competitive markets. Michael Levine’s work is instructive. He uses the example of cattle, which are generally sold as whole animals in a competitive market. The butcher’s cost of preparing particular cuts does not vary in any significant way, and those cuts are again sold in quite competitive markets. Yet, ultimate consumer prices vary considerably depending on the desirability of the cut of meat. Although the comparison between wealthy customers and filet mignon may be somewhat crude, the value of high spending consumers to merchants may justify higher card acceptance fees for the cards used by big spenders in much the same way that the desirability of the tender cuts leads to higher prices despite competition.
All this suggests that interchange fees and price discrimination based on type of card would exist in an efficient and competitive credit card market. But these pricing practices do not ensure that the market we have is in fact efficient and competitive. If above cost pricing and discrimination are not determinative, what can we look to in order to evaluate the competitive performance of credit card markets? My next post will comment on that issue.

The Ubiquity of Interchange Fees

I am very pleased to join the Commercial Law Blog as a guest, blogging about credit card payments. Before discussing the economic effects of current fee structures and how card pricing might be improved, this post lays some groundwork, suggesting that these fees are best understood as the portion of the merchant discount fee that a credit card system uses to support card issuing. Viewed in this way, all credit card systems in the United States charge the economic equivalent of interchange fees.

Back in the early days of credit cards, virtually all banks in the associations both issued cards and signed merchants to accept them, a function known as merchant acquiring. The systems then required that the entire merchant fee go to the issuing bank. Over time, this fee structure, channeling all revenue to the issuer, did not provide sufficient incentives to add merchants to the network. To remedy the problem, the two bank associations that became Visa and MasterCard adopted a system-wide formula for dividing the merchant fees between issuers and acquirers.

Functionally, acquirers paid merchants a discounted price for credit card paper and then sold that paper to the card-issuing bank at a somewhat lower discount. The total merchant fee came to be called the “merchant discount” and the portion passed on to the card-issuing bank was labeled the “interchange reimbursement fee.” The amount retained by the acquirer never got a formal name, but might have been called the short-end-of-the-stick fee. From early on, interchange raised antitrust concern because it enabled card-issuing banks to avoid competition on the fees that they effectively charged to merchants. Nevertheless, it has withstood legal challenge for more than three decades.

Over the years, the interchange fee has evolved. Although Visa’s and MasterCard’s fees differ in some ways, they have both followed a similar path. Initially, each charged a single fee to all merchants. In the 1980s, the associations developed separate fees for paper and electronic transactions. The 1990s brought different fees for certain merchant types, as the systems sought to bring in lower margin retailers such as supermarkets. They also added a separate fee for situations in which the magnetic stripe could not be swiped, reflecting perceived fraud risks. Today, interchange fee schedules are a complex array of charges that vary depending upon the type of merchant and its card sales volume, the type of transaction, and the type of card used. The most significant factor may now be what one might term the incremental reward fee, a higher interchange fee that applies when a customer uses a card that rebates cash, awards airline miles, or provides some other benefit for using the card. In addition, as technology has improved and merchant acquiring has become more competitive, acquirers have reduced their margins at the same time that the systems have increased interchange fees. As a result, the percentage of the merchant discount paid to issuers has increased.

Because the phrase interchange fee was created by the bank-card associations, and antitrust challenges -- including the on-going merchant litigation -- principally attack the lack of competition among Visa and MasterCard issuers, it is often assumed that the economic implications of interchange are limited to the bank card associations. But that isn’t true. Although American Express and Discover do not have a formal interchange fee, they have the functional equivalent: A merchant fee that exceeds the marginal cost of providing the retailer with card-acceptance services plus normal profit.

The four-party (issuer/cardholder & acquirer/merchant) nature of a Visa or MasterCard transaction makes this economic equivalence in fee structure apparent. Visa/MasterCard acquirers now operate profitably on about one quarter of the merchant discount that they take from retailers, passing the remaining three quarters to card issuers. Three-party systems (joint issuer-acquirer/cardholder/merchant), such as American Express and Discover, charge merchant fees that exceed substantially the revenue that Visa and MasterCard acquirers retain. Surely, the three-party systems, like Visa and MasterCard banks, use this excess merchant revenue to stimulate card use. For example, American Express now uses some of its merchant revenue to pay banks to issue AmEx cards. Although the percentage of the merchant fee used to support card issuing varies across systems, in all cases more than half of what retailers pay probably supports card issuing. Next time, I will blog about the economic effects of generating revenue from merchants that is used to stimulate card use.