Speech Payments System Reforms: Innovation and Competition
Assistant Governor (Financial System)
Cards & Payments Australasia 2009
It is a pleasure for me to be able to address the 14th Annual Cards and Payments Australasia conference this morning.
The subtitle of this conference is ‘Payment Innovation for Banks, Retailers and Government’. In my remarks this morning, I would like to focus on the first two words in this subtitle – that is ‘payment innovation’, as well as the closely related concept of ‘competition’. This focus reflects the fact over the longer run it is innovation and competition that are two of the key drivers for a more efficient payments system. Indeed, much of the work of the Payments System Board over recent years has been focused on creating an environment in which competitive forces are able to work for the long-term benefits of consumers, and on addressing some of the roadblocks to innovation in Australia's payments system.
There are three specific areas that I would like to talk about this morning – firstly, the recent reforms of the ATM system; secondly, the conclusions of last year's review of the reforms to the card payment systems; and thirdly, the architecture and governance of Australia's bilateral systems.
As you are no doubt aware, these reforms finally came into effect earlier this month after a very long and complicated gestation. At their heart, the reforms are about: improving competition in the provision of ATMs in Australia; increasing transparency to consumers; and ensuring that there are incentives that encourage innovation and the widespread availability of ATMs.
As has been widely recognised, the previous arrangements had at least three significant weaknesses.
The first was that an owner of ATMs – unlike almost every other business in the country – was unable to determine the price it charged its customers for using its services. Instead, if a cardholder used an ATM that was not owned by its bank, the owner of the machine would receive a so-called ‘interchange fee’ of around $1 from the bank where the cardholder's account was held. This fee had been fixed for many years, and it was all but impossible for the owner of an ATM to negotiate a higher fee.
While this arrangement had served us reasonably well in the past, it had come under considerable strain. As the cost of providing ATM withdrawals had risen over time, there was a growing risk that non-bank owners of ATMs would find it unprofitable to deploy machines in many locations. Given that almost one in two ATMs in Australia is owned by companies that are not financial institutions, the end result would have been a reduction in the number of ATMs in Australia, ultimately reducing choice and convenience for consumers.
The second weakness of the previous arrangements was a general lack of transparency. While ATM owners did not charge cardholders who used their machines, most cardholders were charged a fee by their own bank – these fees were commonly known as ‘foreign fees’ or ‘disloyalty fees’. Many banks also charged their customers a foreign fee when they simply checked the balance of their account before withdrawing funds. These foreign fees were not displayed at the time of withdrawal, with financial institutions arguing that the messaging systems underpinning the ATM system, and the way that transaction accounts were structured, did not allow this. Instead, the fees were disclosed in banks' general terms and conditions and debited to the cardholder's account at the end of the month.
Many people said that they found these arrangements confusing and that they were not always aware of the cost of using another institution's ATMs. Over recent times, there was also increased questioning of why many banks charged a foreign fee of $2 for withdrawals, when the interchange fee they paid to the owner of the ATM was only around $1. Similarly, there was also questioning of why balance enquiries often attracted a foreign fee of around $2, when the interchange fee on these enquiries was, on average, only around 75 cents.
The third weakness related to access. Over several years, the Reserve Bank had received numerous complaints about the difficulties that new entrants faced when entering the ATM market. Many of these difficulties stemmed from the bilateral arrangements underpinning the ATM system. Under these arrangements, new entrants need to knock on the door of each of the existing players and establish a relationship with them, rather than being able to enter the system through a single point of access. Not surprisingly, the existing players have not always rushed to welcome new participants in the system, which they often see as competitors.
The recent reforms have addressed each of these weaknesses.
They allow the owners of ATMs to determine their own prices, with these prices set in a much more competitive environment than was previously the case. This is a much better situation than ATM owners having their revenue controlled by the banks. The reforms have also greatly increased transparency to consumers, with this transparency an important part of strengthening the competitive forces within the system. And the reforms have also led to simplified access arrangements although, as I will discuss in a moment, more needs to be done here.
While it is still early days, the competitive forces are playing out broadly as expected. Initially, two of the four large banks announced that they would retain a foreign fee, albeit a lower one than previously. This meant that their customers would have been charged twice if they used another institution's ATM – once by the owner of the ATM, and once by their own bank. In our view this was against the spirit of the reforms. Not surprisingly, there was a swift reaction by these banks' customers and, as a result, they have now abolished their foreign fees. This is a welcome development and is a good example of the competitive process at work and the power of consumer reaction.
The Reserve Bank has made its views on this issue very clear on a number of occasions. While we recognise that the setting of foreign fees is ultimately a matter for each bank, our view is that the system will work better without these fees, and that the case for them is weak. This is particularly so, given that most banks charge cardholders a fixed monthly fee for operating a transaction account, and now that interchange fees have been abolished, the cost to a bank of its customers using someone else's ATM is very low, almost certainly less than 10 cents a transaction.
Under the new arrangements, most ATM owners are charging a $2 withdrawal fee, although one large bank is charging $1.50, and some owners are charging as low as $1. For balance enquiries there appears to be more variation in fees across institutions, with some charging the same fee as for cash withdrawals, while others are charging less than $1, and there are some examples of ATM owners charging nothing. Where fees are imposed, they are always disclosed before the cardholder withdraws the cash, or makes a balance enquiry, and they do not apply if the transaction is cancelled.
Importantly, under these reforms, most cardholders are able to continue to use ATMs owned by their own institution without charge. The new arrangements also provide considerable flexibility for small institutions in how they join the ATM system and how they, and their customers, pay for access to large networks. Some smaller institutions have established agreements with large networks to provide fee-free withdrawals to their customers, while others have joined with other small institutions to form a fee-free sub-network. In a few cases, they have decided to re-adjust their product offerings so that their customers now pay for withdrawals from some machines when previously they did not. Overall, however, across the entire system most cardholders are paying no more for ATM transactions than they were previously, and may have the opportunity to pay less.
One concern that arose prior to the implementation of the reforms was the possibility that some ATM owners would impose exorbitant fees in locations where there was limited competition. To date, these fears have not been borne out, with the major networks having a single price that applies across the network, or a cap on the price that can be charged by members of the network.
Over the months ahead, the Reserve Bank will continue to monitor developments closely. We have asked ATM owners to provide us with details of their direct charges on a regular basis, including whether charges vary across locations. We will also continue to monitor foreign fees and transaction volumes and to report publicly on developments. Interestingly, our liaison so far suggests that the increased transparency of the fees is already having an effect. In particular, some ATM owners have reported that the number of withdrawals from their machines has declined, with some customers deciding not to proceed with a withdrawal once they are reminded of the cost. We will get a better picture of how extensive this change has been in a few weeks time, when banks and others report their ATM statistics to the Reserve Bank for the month of March.
In summary then, we are confident that the reforms will deliver benefits for consumers. They have strengthened the competitive forces in the ATM system and made the fees much more transparent to consumers. Equally importantly, the industry is on a much sounder foot than it was previously. Now that ATM owners can determine their own prices within the context of a competitive marketplace, they have an increased incentive to innovate and to grow their networks. Over time, this will deliver both more choice and more convenience to consumers.
The Conclusions of the 2007/08 Review
The second issue that I would like to talk about is the conclusions of the payments system review undertaken by the Payments System Board last year.
The review had two central sets of conclusions.
The first was that the reforms had:
- improved the competitive pressures in the payments system;
- increased transparency;
- delivered better access arrangements; and
- improved the price signals in the system for consumers
Given this conclusion, the Board saw no case for allowing the schemes to once again be able to impose no-surcharge rules on merchants, or to require merchants to accept a scheme's debit cards as a condition of accepting its credit cards.
The second conclusion was that the improvements in the competitive environment had made it possible for the Board to now consider stepping back from one specific aspect of the regulations – namely the regulation of interchange fees. However, as the Board made clear, it is only prepared to move in this direction if the industry steps forward to address its ongoing concerns about the competitive forces on these fees. While these forces have undoubtedly been strengthened by the various reforms, there remains a significant risk that the unusual nature of the competitive dynamics in the system could see these fees move higher if the current interchange regulations were removed and no other changes to the current arrangements were made. The Board has made it clear that it sees such an outcome as undesirable, and it does not accept the idea that higher interchange fees in the credit card system would improve the efficiency of the overall payments system.
The Board has laid out two possible paths by which industry could address its concerns in this area. One is for the industry to take further steps to strengthen competition. These steps could include:
- changes to the governance of the EFTPOS system to improve its ability to compete with the international card schemes;
- further modifications to the honour-all-cards rule to allow merchants to accept some cards, and reject others, based on the costs and benefits of accepting the various cards;
- the development of alternative payment methods to provide consumers with greater choice when making online payments; and
- greater transparency of scheme fees.
While the Board sees changes in these various areas as desirable, it has not been prescriptive about the precise details of any changes, including the use of particular technologies or payment products. Instead it has focused on the general principle of improving competition.
A second possible path is for the international card schemes to commit to limiting the weighted-average credit card interchange fee to the current level of 0.5 per cent. Such a commitment would obviously address the Board's concerns that credit card interchange fees could rise if the current regulations were removed. Also, the Board flagged the possibility that if the schemes were prepared to make voluntary changes to their scheme rules, other aspects of the current regulations might also be able to be lifted. This is consistent with the Board's view that regulation should only be used if industry-based solutions cannot be found.
When announcing its conclusions, the Board indicated that it would assess industry progress in August this year. If at that time, its concerns have been adequately addressed, the regulation of interchange fees could be lifted, probably in November. Otherwise, regulation will continue, with interchange fees being reduced further. As the Board made clear at the time, its preferred approach is to lift the current regulation of interchange fees, but it is not prepared to do so unconditionally.
So what progress has been made since the conclusions of the review were released?
Here, I think it is fair to say that some progress has been made on both possible paths, but there is still a considerable way to go before we can see the finish line.
In terms of the first path – that is, a further strengthening of the competitive forces – the main positive development is the work that APCA and its members have done on the development of improved governance arrangements for the EFTPOS system, including the establishment of a formal scheme to oversee the system. Invitations have recently been issued to join the scheme and it is anticipated that it will be up and running later this year.
These draft arrangements look to be a significant improvement on those currently in place. They envisage a board overseeing the EFTPOS system, with the board having a number of independent directors. If adopted, the scheme could help promote co-operation within the system and provide a mechanism for decisions to be made in the best interests of the system, rather than the best interests of individual members within the system. Whether this is indeed the case will depend upon the details, but at least there has been progress in the right direction.
On a somewhat less positive note, there appears to have been less progress on the development of alternative online payment methods. Over the past couple of years, industry participants had been working, through BPAY, on the development of a new payment method for online payments. Recently, however, despite considerable work having being completed, it was decided to postpone the project until at least the middle of this year. Our liaison suggests that while some industry participants were keen for the project to proceed, others were not. Without wanting to offer a comment on the merits of the particular proposal, this experience is another example of how difficult it can be to make progress when all the main stakeholders need to be on board at the same time. It might also provide some useful insights into the appropriate governance model for other payment systems, including the EFTPOS system.
The Bank's recent focus on online payments reflects a couple of considerations. One is that in many situations, consumers wishing to buy goods online have few payment choices other than to use a card issued by the international schemes. This lack of choice weakens competition, and is likely to become a bigger issue as online commerce continues to grow.
Another consideration is that fraud rates on online transactions appear to be steadily increasing. Almost half the fraud on credit cards occurs in situations where the merchant does not physically see the card, with the fraud rate increasing by around 50 per cent over the past year. If this trend were to continue, it could undermine consumer confidence in transacting online which would have obvious costs.
While the international card schemes have made considerable efforts to address this rise in fraud, more needs to be done to offer consumers highly secure payment options. One possibility that has been raised by the Reserve Bank before – and that has been implemented in other countries – is to be able to make payments to an online merchant from a deposit account using the customer's internet banking facilities. Such an option, however, is not yet currently widely available in Australia.
The general point here is that further progress is required in the area of online payments, both to improve competition in the payments system and to ensure that online payments can be made safely and securely.
As I mentioned a moment ago, another way in which the competitive environment could be improved is to change the honour-all-cards rule to give merchants greater freedom than they currently have to accept and reject cards. We have discussed this idea with the international card schemes on a number of occasions, and it is fair to say that they have little appetite for it. However, if sufficient progress has been made by industry participants in other areas to allow the Bank to step back from interchange regulation it would consider the case for using regulation to require the schemes to further modify their honour-all-cards rules as part of an overall package.
In terms of the second path – that is a voluntary commitment from the schemes to keep interchange fees to no more than current levels – the Bank has had several discussions with schemes over recent months. While these discussions are ongoing, the schemes have not ruled out this possibility, with the discussions focusing on the practicalities of any commitment, including the need to ensure that any arrangements are competitively neutral across the schemes. We hope that further progress can be made here.
We are also discussing various possibilities with the schemes for improving the transparency of scheme fees. One possibility is for them to disclose the average scheme fee paid by acquirers for some standard types of transactions. A second is for the schemes to disclose their ‘rack rates’ for the specific fees that are most relevant for Australian transactions. And a third is for the schemes to permit acquirers to disclose to merchants what they are paying in scheme fees, and provide the Bank with information on the average scheme fee to allow this to be monitored over time. We have not yet settled on the appropriate model, but are hopeful that an outcome can be found that promotes transparency while at the same time respects commercial confidentiality.
The final point I would like to make here is that the Bank remains keen to continue to explore both of these paths. Time is marching on however, and further progress is needed. Many in the industry have argued for the interchange fee regulations to be lifted, and given the changes that have occurred in the payment landscape since these regulations were introduced, the Bank is prepared to consider doing so. It will only move in this direction though if industry itself is able to take steps to address the various concerns about the competitive forces in the system.
Architecture and Governance
The third issue I would like to address relates to the general architecture and governance of Australia's payment systems. Over recent years, the Bank has increasingly focused on this issue. This reflects our concerns that the existing arrangements are not particularly conducive to certain types of innovation, and that if changes are not made, there is a significant risk that Australia will end up with a payments system that is unacceptably behind best practice.
Our main focus has been on the so-called ‘bilateral systems’ – namely the ATM and EFTPOS systems, as well as the direct entry system that is used for the payment of such things as salaries and dividends. The term ‘bilateral’ is used here as each of the main participants in these systems has bilateral business and technical links with each of the other participants. This is in contrast to almost all overseas payment systems, and the BPAY and credit card systems in Australia, where institutions join a ‘scheme’ and thus do not need to establish direct bilateral relationships with each member in the system.
These bilateral arrangements have generally served us well over many years, and were useful in the original development of the systems. They are, however, not particularly friendly to new entrants. As I said earlier, the access arrangements that have been put in place for the ATM system represent an improvement over previous arrangements, but more needs to be done. In particular, there is a strong case for access to be further streamlined so that a new entrant to the ATM system does not need to go and talk to all the existing players to enter the system. The same is true for the other bilateral systems.
Perhaps even more importantly, these bilateral systems are characterised by co-ordination problems which can slow the pace of innovation. None of these systems has an ‘owner’ or a ‘manager’. And none of them are overseen by a board and management whose job it is to promote and develop the system. Not surprisingly then, none of them has a particularly good record of innovation. Over the years, various proposals have been floated for change, but progress has been limited. While this may simply reflect the fact that these proposals did not meet the demands of the market place, our sense is that the difficulty of co-ordinating decisions across institutions has also been a factor.
The key observation here is that co-ordination is sometimes required to make progress. Payment systems are networks and for networks to work, institutions must sometimes co-operate. Of course, institutions must also compete, and so the challenge the industry faces is how to promote competition in the areas where it is required, but at the same time promote co-ordination where it is required. This theme is going to be taken up in more detail in a speech tomorrow by Governor Glenn Stevens.
Looking forward, there is a strong case to re-examine the balance that has been struck in the Australian payments system between competition and co-operation. Financial institutions have been very good at competing on developing payment products using the existing infrastructure, but they have not been so good at co-operating to ensure that the infrastructure is improved over time. Ideally, we would have world-class payment products, delivered on world-class infrastructure, but unless the fundamental co-ordination problems in these networks can be addressed there is a risk that this will not occur. These co-ordination issues are best solved by industry, however, if this cannot be done, other options will need to be looked at over the period ahead.
Thank you very much for your time this morning.