Payments System Board Annual Report – 2005 Credit and Charge Cards

The Bank designated the credit card schemes of Bankcard, MasterCard and Visa in April 2001. Following an extended period of consultation, the Bank then set standards relating to the so-called no surcharge rule and interchange fees and imposed an access regime on these schemes. The standards became effective from January 2003 and October 2003 respectively, while the access regime became effective from February 2004. Given the passage of time since the reforms were implemented, it is possible to make a preliminary assessment of their effects.

The most notable impact of the reforms has been a marked reduction in merchants' costs of accepting credit cards, which in turn, is flowing through into lower prices of goods and services for all consumers. As expected, the reforms have also prompted an increase in the effective price of credit card transactions and promoted greater competition, particularly in card issuing, but also in the provision of credit card services to merchants. Finally, the reforms have put some downward pressure on the average fees that American Express and Diners Club charge merchants although the decline in fees has been less than expected.

Merchants' Costs and Prices

Data collected by the Bank from financial institutions show that the average merchant service fee for credit cards in the June quarter 2005 was 0.92 per cent (see Graph 2). This compares with 1.40 per cent immediately prior to the standard on interchange fees becoming effective. It is also considerably lower than merchant fees in most other countries; in the United States, for example, the average fee in the Visa scheme in 2004 was 2.08 per cent.

The fall in the average merchant service fee since the reforms is significantly larger than the decline in the average interchange fee (0.48 of a percentage point compared to 0.40 of a percentage point). It suggests that, not only have banks fully passed through to merchants the fall in interchange fees, but the increased transparency and focus on these fees has led to greater competition amongst acquirers for merchant business. Acquiring margins in Australia are now comparable with those in the United States, where there is strong competition and considerable economies of scale.

The average merchant service fees charged by American Express and Diners Club have also fallen since the reforms came into effect. The reductions have, however, been smaller than those for Bankcard, MasterCard and Visa – in the case of American Express it has been around 0.15 to 0.20 of a percentage point to 2.36 per cent, while in the case of Diners Club it has only been around 0.05 of a percentage point to 2.3 per cent. The reasons for these relatively small declines are discussed in detail below.

Overall, the fall in merchant service fees in both the credit card and American Express and Diners Club schemes has meant that over the 12 months to June 2005, merchants' costs were around $580 million lower than they otherwise would have been. This figure takes into account the fact that there has been a small increase in the combined market share of the higher-cost American Express and Diners Club schemes.

These lower merchant costs are feeding through into lower prices for goods and services (or smaller price increases than otherwise would have occurred). While merchants would undoubtedly have hoped that these lower costs translated into increased profits, competition means that just as the banks passed on their lower costs to merchants, so too must merchants pass on their lower costs to consumers. It is, however, not possible to monitor the speed and extent to which this is occurring, as the effect is relatively small compared to changes in the overall price level in the economy. The Bank estimates that when fully passed through, the Consumer Price Index (CPI) will be 0.1 to 0.2 percentage points lower than it otherwise would have been as a result of the reforms. There are no statistical techniques with fine enough calibration to separately identify this change against a background where the overall CPI increase is about 2.5 per cent. But the fact that it cannot be separately identified does not mean that it has not happened.

Price Signals

As noted in the introductory chapter of this Report, a major goal of the reforms was to promote more appropriate price signals to cardholders. As expected, this has been achieved both through merchants directly charging users of credit cards and a reduction in the value of reward points.

Surcharging

A number of private sector surveys indicate that around five per cent of merchants are imposing an explicit charge on those who use a credit card to pay. The surveys also suggest that a considerable number of merchants are considering introducing such a charge. Most of those firms that already charge impose the same fee for all credit and charge cards, although some do charge more for American Express and Diners Club, reflecting the higher cost to merchants of accepting these cards.

Examples of firms charging can be found in many industries, including telecommunications, restaurants, bars, travel agents, airlines, whitegoods and electrical retailers and removalists. Some of these firms operate in highly competitive industries and have low margins. They recognise that credit cards are a convenient way for their customers to pay for goods and services, but they do not want to carry the extra cost of accepting credit cards. Imposing a charge allows them to accept credit cards, with the customer then free to choose whether the value they receive from using the card exceeds the cost of doing so. Similarly, a number of organisations such as schools, clubs and societies, and government authorities now permit payment with a credit card, imposing a charge on customers using this form of payment.

Despite some merchants charging for credit cards, many merchants remain reluctant to do so. In part, this reflects the long history during which they were prevented from levying such a charge by restrictions imposed by the credit and charge card schemes. These restrictions created a system in which cardholders expected to be able to pay the same price regardless of the method of payment chosen, irrespective of the cost to the merchant. This expectation is now breaking down, and, in time, the extent of surcharging is likely to increase. The Bank encourages all merchants to actively consider differential charging based on their costs of accepting various payment methods. Ultimately, such an approach is likely to work in the best interests of all users of the payments system, with consumers choosing between various payment methods based on effective prices that reflect the underlying costs of providing the various payment methods.

Reward schemes

A related impact of the reforms has been a reduction in the value of reward points, and an increase in annual fees. In 2003, a cardholder with a card issued by one of the four largest banks would have had to spend an average of $12,400 to receive a $100 shopping voucher; today they would have to spend $15,100 (Table 2). Using these figures as a guide suggests the value of reward points has fallen from over 0.80 per cent of the amount spent, to around 0.65 per cent currently. In addition, most card issuers have increased the average annual fee for having a credit card with a reward scheme, and many have placed a cap on the reward points that can be earned.

Price signals and the use of credit cards

While these changes have increased the price of credit card transactions relative to debit card transactions, many cardholders typically still face a negative price for credit card transactions due to the combination of interest-free credit and reward points. However, where a surcharge is imposed, cardholders now typically face a positive price, although the exact price depends upon the size of the surcharge and the value of any reward points and interest-free period.

While experience suggests that payment patterns change only slowly over time in response to changes in relative prices, growth in credit card spending does appear to have slowed over the past year relative to spending on debit cards. Between 1998 and 2000, the number of credit card transactions grew at an annual rate averaging around 30 per cent, compared to average growth of 10 per cent in the number of debit card transactions. Growth rates then converged between 2002 and 2004, with the number of credit and debit card transactions both growing at around 10 per cent per annum. More recently, the number of credit card transactions has been growing slightly more slowly than the number of debit card transactions (Graph 3).

Overall, the number of credit card transactions in Australia still exceeds the number of debit card transactions by a small margin, although the value of spending on credit cards is more than twice that on debit cards, reflecting the larger average value of a credit card transaction.

A common benchmark interchange fee

Concerns by some industry participants about the impact of small differences in interchange fees between the main credit card schemes show how important relative prices and costs can be in influencing outcomes in the payments system.

Under current arrangements, interchange fees in each scheme are capped on the basis of a benchmark determined by eligible costs incurred by issuers in that scheme. When the benchmarks were calculated, costs were lowest in the Bankcard system and highest in the MasterCard system, and this is reflected in the interchange fees in these systems (see Table 3). In particular, the interchange fees in the MasterCard system are currently two basis points higher than those in the Visa system.

Over the past year, a number of industry participants have noted that this two basis point difference could be giving MasterCard a competitive advantage in attracting issuers, particularly if it was not offset by higher costs. Data available to the Bank suggested that this may have been the case, with at least part of the higher MasterCard benchmark reflecting the particular characteristics of its issuers' portfolios at the time the benchmarks were calculated.

In response, in July 2005 the Bank sought public comment on whether a common benchmark fee across all three systems would improve the efficiency of the system. After considering the submissions put to it, the Bank released a draft revised interchange standard that would have the effect of establishing a common benchmark that would apply across all three schemes, with the benchmark retaining the existing definition of eligible costs. The Bank is still consulting on the proposed change.

Competition

As noted above, the increased transparency of interchange fees and merchant service fees has contributed to greater competition among existing institutions in the provision of credit card services to merchants. In addition, MoneySwitch, the first organisation seeking to specialise in the provision of acquiring services (including both credit and debit card acquiring) to merchants was authorised by APRA as an SCCI in March 2005.

MoneySwitch is now in the process of applying for membership of the MasterCard and Visa schemes under the Bank's access regimes. At an early stage in the application process, Visa indicated to the Bank that its international rules might prevent it accepting MoneySwitch's application, since the Bank's credit card access regime, which overrides Visa's international rules in Australia, strictly only applies to Visa credit cards and not Visa Debit cards. Such an outcome would have been clearly contrary to the intent of the Bank's reforms. In response, the Bank imposed an access regime on the Visa Debit system in late August 2005. Further details are provided in the following chapter.

The impact of the Bank's reforms on competition can also be seen on the issuing side of the credit card market. In particular, the fall in interchange revenue has encouraged issuers to re-evaluate their business models. Previously, many issuers competed for cardholders by offering attractive reward schemes, but following the reforms, competition has focused much more on interest rates. This reflects the fact that the attractiveness to issuers of cardholders who do not pay interest, and who redeem reward points, has been significantly reduced by the cut in interchange fees. In some cases, credit card issuers have responded by encouraging these customers to move to American Express and Diners Club and, as noted above, they have also devalued or capped reward points.

In contrast, the relative attractiveness of those cardholders who regularly pay interest has increased. In response, some issuers have sought to attract these cardholders by offering them much lower interest rates. Some of the new entrants, including Virgin and Aussie Home Loans, have targeted market segments – youth and home buyers – that are more likely to be interest-rate sensitive than are those cardholders who typically pay off by the due date, and so pay no interest. Some of the major banks have also recently introduced low-rate cards.

Of the new non-bank entrants, only GE Money has elected to become an SCCI. Both Virgin and Aussie Home Loans have instead entered the market in partnership with an existing bank. While neither organisation took up the opportunity of joining the credit card schemes in their own right, their ability to do so no doubt increased their bargaining power vis-a-vis their bank partners.

Overall, consumers are benefiting from this greater competition and lower merchant costs, although outcomes vary considerably across consumers. One group of consumers clearly better off are those who regularly borrow on their credit cards. They are now able to obtain a card with an interest rate of 10 to 13 per cent, rather than the 16 to 18 per cent payable on traditional cards. For many consumers the resulting savings can run into hundreds of dollars per year. These consumers are also benefiting from their share of the $580 million in merchant savings.

Consumers who do not use credit cards at all are also benefiting from the reforms as they are paying lower prices for goods and services than would otherwise have been the case. For many years, these consumers have helped subsidise the generous reward points of the credit card issuers through paying higher prices for goods and services. The reforms have helped unwind some of this subsidy.

Finally, those cardholders who accumulate large numbers of reward points have, as expected, seen the value of reward points cut and/or annual fees for belonging to a rewards scheme increase. These cardholders are clearly not getting the same benefits as before, although like other consumers, they are benefiting from lower merchant costs. In the Bank's view, the cut in reward points, the increase in annual fees and the use of credit card surcharges are important steps towards better aligning relative prices and costs, and thus making the payments system work in the best interest of all its users.

American Express and Diners Club

As noted above, the fees that American Express and Diners Club charge merchants have fallen over the past few years, but not by as much as merchant fees in the other schemes. This outcome reflects not only differences in regulation, but also importantly the differences in the competitive dynamics in the regulated credit card schemes and those in the American Express/Diners Club schemes.

In the Bankcard, MasterCard and Visa schemes, there is considerable competition among institutions in the acquiring of transactions from merchants. As a result, if a merchant is not satisfied with the fee being offered by its acquirer for transactions on cards issued under these schemes, it can go to any one of a number of other institutions to seek a better deal. Aiding in this process are brokers who will help merchants identify the banks prepared to offer them a lower merchant service fee.

In contrast, the competitive dynamics are quite different in the American Express/Diners Club schemes. A merchant unhappy with the fee being charged by one of the schemes can only negotiate with that scheme; it is simply unable to turn to another acquirer in the hope of obtaining a better deal, as the schemes are the sole acquirers for transactions on their own cards.

Despite facing no competition in acquiring their own transactions, these schemes do compete with the credit card schemes for merchant acceptance. As a result, the competitive discipline on the schemes arises out of their desire to have their cards widely accepted by merchants, rather than as a result of competition between acquirers. Over time, as merchant service fees for credit cards have trended down, this competitive pressure has seen the fees charged by American Express/Diners Club also fall.

The fact that this decline in fees has been less than that in the credit card schemes has led to periodic calls for the Bank to regulate American Express and Diners Club in the same way as it regulated the other schemes. At the time the credit card schemes were regulated, it was, however, simply not possible to regulate American Express and Diners Club in the same way, as there were no interchange fees in these schemes. Instead, the Bank has sought to address the market power that American Express and Diners Club have as a result of being the sole suppliers of their particular services to merchants. It has focused on improving the information available to merchants and on requiring the removal of restrictions that limit the ability of merchants to negotiate effectively with the schemes.

While the Bank has not formally regulated American Express and Diners Club, these schemes have voluntarily agreed to make a number of changes after discussions with the Bank. In 2002, they agreed to remove the no surcharge clauses from their merchant contracts and in 2005 to remove anti-steering provisions from their contracts. The schemes have also agreed to publish their average merchant fees and their combined market share. As a result of these changes, merchants now have a greater range of options, and better information, when negotiating with American Express and Diners Club. They also have much greater scope to steer customers through both price and non-price means to cheaper forms of payment.

To date, these greater freedoms have had only a limited impact on average fees charged by American Express and Diners Club. In time though, as merchants become more comfortable with using these options, the Bank expects that these fees will come under greater downward pressure as merchants question whether the value they receive from accepting American Express and Diners Club is worth the current margin they pay on these cards.

Because of their higher merchant fees, these schemes have always been able to give cardholders greater rewards for using their cards than are typically provided by issuers of Bankcard, MasterCard or Visa cards. Partly in response, there has been an increase in the combined market share of these schemes over the past couple of years. In the financial year prior to lower interchange fees coming into effect (2002/2003) these schemes accounted for 14.6 per cent of the total transaction value. Over the past financial year, the comparable figure is 16.5 per cent (Graph 4).

This increase was largely concentrated in the second quarter of 2004 and was coincident with the issuance of American Express credit cards by two of the major Australian banks. When these cards were first issued, the Bank considered whether the payments by American Express to its partner banks should be subject to regulation in a similar fashion to that of interchange fees in the credit card system. After detailed analysis, it concluded that there was not a strong case to do so.

This conclusion reflected a number of factors. The first was that a reduction in these payments through regulation would be unlikely to cause a decline in American Express' merchant fees. This is the contrary of the situation with the credit card schemes where regulation of interchange fees saw merchant fees decline immediately. This difference reflects the fact that, as mentioned above, American Express is the sole acquirer of transactions on its cards. This means that unlike in the credit card schemes, the causation runs from merchant service fees to interchange fees, not the other way around.

A second consideration was that if the Bank regulated interchange payments to the partner bank, it was likely that other forms of payment would emerge to take their place. One possible response would have then been to regulate all payments between American Express and its partner banks, including marketing and product support payments. Such regulation would then also be required in the Bankcard, MasterCard and Visa schemes. The Bank's view is that such extensive regulation at this time is not in the public interest, especially when it would have had no impact on the incentives for American Express to issue its own cards.

While in an ideal world regulation would be competitively neutral, designing such regulations is problematic when the various card schemes have different structures and are subject to different competitive dynamics. The Bank's approach has been to focus its efforts on those areas where it has judged that competition is not working appropriately. For the credit card schemes this has primarily involved the regulation of interchange fees, while for American Express and Diners Club it has primarily involved ensuring that merchants are not unnecessarily restricted in their negotiations with the schemes. This approach has delivered significant benefits for consumers, and these benefits are likely to grow through time as merchants use the full range of tools now available to them.