Tuesday, January 5, 2010

Spot Light Shines on Debit Card Interchange (Finally)

For several years now the hot payment card story has been the rising interchange fees effectively paid by merchants to card-issuing banks on credit card transactions. A major class action attacking those fees is well underway, and the Department of Justice, Antitrust Division, has an open investigation.
Commentators have disagreed about whether market competition between Visa, MasterCard, American Express and Discover could yield an appropriate interchange fee or whether more aggressive industry regulation is required. Some say that the only competition is to increase fees to encourage banks to issue a particular network's cards. But some historical evidence suggests that competition among networks does create pressure to lower interchange fees to increase merchant acceptance. There has also been considerable debate about whether interchange fees constitute an unfair tax on those who do not use credit cards.

Surprisingly, however, debit card interchange fees have coasted under the radar since the 2003 settlement in which Visa and MasterCard agreed to pay merchants $3 billion and permit the acceptance of credit cards but not off-line signiture debit cards. At that time, Visa also significantly lowered the interchange fee on its signiture debit cards.
Today's New York Times has a front page story Visa's Strategy in Debit Cards: Push Up Costs by Andrew Martin taking Visa to task for its more recent debit card pricing practices. This attention is long overdue. In contrast to credit cards, the case against Visa and MasterCard's interchange fee pricing practices and the need for regulation are much stronger in the debit arena. Under the right conditions, American Express and Discover could possibly serve as a competitive check on credit card fees, but neither has a significant enough presence in the debit market to challenge the banks issuing Visa and MasterCard. And while the spending flexibility created by credit cards creates significant benefits for consumers and potentially increased sales for merchants -- benefits that may outweigh the cost of credit cards -- debit card benefits are considerably more limited for both consumers and merchants, and their costs are thus significantly less likely to be justified.

The development of debit cards is quite interesting. They began as extensions of ATM cards issued by regional networks of banks with the goal of saving costs by encouraging consumers to switch away from paper checks. Interchange fees were virtually non-existant and, in some cases, banks even paid merchants and consumers to stimulate use of the cards. But banks faced two problems. Like ATM cards, these early debit cards required the entry of a PIN, and most merchants did not have card acceptance systems that could handle PIN entry. Second, because the cards did not generate significant revenue for the banks, they could not justify investing in the advertising necessary to educate consumers about the cards.

Visa responded in the mid-1980s by creating a signiture-based debit card that could run over the Visa credit card network. It permitted any merchant accepting credit cards to also accept debit. And because the card was priced at near credit card levels, the banks were willing to support heavy advertising to stimulate debit card use. The scheme worked. Debit card use exploded.

An initial period of competition arose between Visa and the regional networks (as well as MasterCard) which argued that on-line PIN-based debit was a safer, lower cost option compared to Visa's signiture debit. During this era, Citibank's representative on the Visa board reportedly called the regional network operators "through-put jockeys" because they cared only about increasing volume on the network without paying sufficient attention to bank profits. The campaign thus began to encourage consumers to use signiture debit -- despite the greater potential for fraud and higher processing costs -- through rewards programs and other methods.

These practices led to a mid-1990s major class action led by Walmart and Sears, arguing that Visa and MasterCard illegal tied acceptance of signiture debit cards to credit cards. Six years later, Visa and MasterCard agree to settle the case by permitting merchants accepting credit cards to reject signiture debit and to reduce signiture debit interchange fees.

Although PIN acceptance is now widespread, expensive signiture debit remains a significant market force shifting billions of dollars annually from the retail industry to the banking industry. Why? After the settlement, very few merchants refused to accept signiture debit, fearing that they could lose customers. Today, Costco limits acceptance to PIN debit, and a few other major retailers try to steer customers to PIN, but most do not. In addition, even before the settlement, Visa began a strategy of increasing the interchange fees on its own PIN debit cards, including a major jump in 2007 that left its PIN system's interchange only slightly below its signiture debit interchange. The strategy has had the dual benefit of (1) forcing MasterCard and the regional networks to increase their PIN debit interchange to avoid losing bank support to Visa, and (2) discouraging merchants from disfavoring signiture debit by reducing the pricing spread. A former regional debit network CEO, Ronald Congemi, bemoaned Visa's strategy in the Times article: “What we witnessed was truly a perverse form of competition. They competed on the basis of raising prices. What other industry do you know that gets away with that?”

Critically, debit card issuance is much less costly for card issuers than credit card issuance. Debit cards are issued virtually costlessly to checking account holders as part of the ATM card package. Moreover, they carry virtually no credit risk for the issuer, as the money for the charge is removed from the checking account promptly for signiture debit and immediately for on-line PIN debit. On-line PIN debit also dramatically reduces fraud risk.

Perhaps because credit interchange fees have increased so much, debit cards may appear to be a good deal for merchants. But given the cost differences for card issuers, debit card fees may be much less justifiable and thus a more appropriate target for regulatory attention.

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