RDP 2014-14: The Evolution of Payment Costs in Australia 2. Related Literature and Scope

The Bank's 2007 study (Schwartz et al 2008) was among the first to use data collected directly from financial institutions and merchants to estimate the costs of making retail payments. Earlier studies had instead tried to estimate costs indirectly or focused on a narrower set of instruments (e.g. Food Marketing Institute 2000; Gresvik and Øwre 2003). The indirect measurement of costs – often via information on fees – arose because of the difficulties of obtaining commercially sensitive cost information. While fees are a reasonable proxy for costs in some situations, there are other instances where they are not sufficient given that profit margins are not separately identified and so are also captured in this measure of costs.

Since the Bank's 2007 study, payment cost studies using proprietary data have been conducted almost exclusively by central banks as part of their role overseeing the efficiency of payments systems. These include a comprehensive study by Gresvik and Haare (2009) in Norway and a study coordinated by the European Central Bank (ECB) published in 2012 (Schmiedel, Kostova and Ruttenberg 2012).^[2] Results across different countries estimated the cost of consumer-to-business payments at between 0.42 per cent and 1.35 per cent of GDP. Most of this dispersion arises from differences in underlying costs between countries rather than sectoral coverage.

In general, studies undertaken since the Bank's 2007 cost study are similar in scope and methodology. In all cases, estimating the benefits of payments has been beyond the scope of these studies given the difficulties of defining and measuring these benefits. Any differences in scope or coverage have generally reflected national circumstances. For example, most countries participating in the ECB study did not include costs associated with cheques given they are generally not used extensively for retail payments in most of Europe.

2.1 Measurement of Costs

Studies of payment costs have focused almost exclusively on measures of long-run costs, which includes both the cost of the infrastructure required to support payments and the cost of making payments using that infrastructure.^[3] For example, when applied to card payments, this long-run cost concept covers both the cost of point-of-sale terminals as well as the cost of conducting card transactions using this equipment. In practice, the average cost of making payments has been used as an estimate for long-run costs given the difficulty of measuring infrastructure costs that may be fixed in the short term but variable in the long term.

One respect in which the measurement of costs differs across studies relates to how prescriptive each study has been around the allocation of costs that might be common to payment instruments and other business functions. Allocation is required because much of the infrastructure that supports payment transactions also facilitates other functions for financial institutions and merchants, such as managing statements and invoicing. To address this, some studies have taken a prescriptive approach as to the types of costs to allocate to payments in order to improve consistency across respondents, while others – including this study – have left these allocations to responding institutions to better account for differences in the structure of each.

2.2 Resource Costs, Private Costs and Transfers

When considering costs incurred by financial institutions, merchants and consumers in facilitating and making payments, most studies distinguish between resource costs and private costs. Resource, or social, costs are the economic resources expended by the various participants to ‘produce’ a payment (Schwartz et al 2008). Additionally, participants may also incur or receive transfer payments from other parties; combining these with the resource costs incurred by a participant generates the net private cost for that participant. These transfers are not resource costs as they are merely a redistribution between participants in the payments system rather than ‘real’ resources spent on the system as a whole. For example, a transaction fee paid by a merchant to its bank represents a transfer and a private cost to the merchant, but not a cost for society as a whole. Estimates of private costs are particularly useful in gauging the incentives for different parties to provide or use different payment services.

While resource costs have been the primary focus of international studies, analysis of institutions' private costs has also been considered in a number of studies (e.g. Brits and Winder 2005; National Bank of Belgium 2006). Some studies have also combined this with an analysis of fixed and variable costs, thereby allowing for a consideration of how private incentives may change at different payment values and how these compare to socially optimal outcomes (Danmarks Nationalbank 2012; Segendorf and Jansson 2012).

2.3 Fixed and Variable Costs

Payment costs can be categorised into fixed and variable components. Fixed costs are generally infrastructure-type costs that would be incurred regardless of the number of payments made, while variable costs are those that depend on the number or value of transactions undertaken. The ability to distinguish between fixed and variable costs permits comparison of the cost of particular payment types as the transaction value varies. It can also inform the extent to which different payment instruments benefit from economies of scale.

The categorisation of costs as fixed or variable will differ to some extent between different institutions. This study asked financial institutions and merchants to indicate whether different cost items are fixed or vary with transaction volumes and values. Different cost items were then allocated as fixed or variable using this information.

2.4 Institutional Coverage and Data Collection

Institutional coverage is broadly similar across different studies of payment costs. Studies conducted by central banks tend to rely on direct surveys of the costs of financial institutions and merchants. Some studies collect additional data directly from companies that provide services to these entities, such as cash-in-transit companies, to examine more detailed aspects of resource and private costs (Segendorf and Jansson 2012). This paper follows the same approach as the Bank's 2007 study by directly surveying financial institutions and merchants, and proxying the resource costs of their service providers by using the fees paid to them, paying careful attention to avoid double counting between resource costs and transfers.

Participation by financial institutions across other studies is typically quite high and the major banks of each country are generally represented. Merchant coverage is more varied, ranging from a handful of firms to over 1,000. For studies with a smaller number of respondents, merchant samples are usually focused on larger merchants. Even for studies involving a wider range of merchants, the cost information from larger merchants has tended to be more complete and up to date (Schmeidel et al 2012) and certain industries appear to have been more responsive (for example, see comments by Gresvik and Haare (2009)). This study includes 17 large merchants, and has used a survey of small merchants (with around 260 respondents) to better understand any differences in costs faced by these businesses.

Estimates of the costs incurred by consumers in using payment instruments are often included in payment cost studies as extensions. Studies that consider the cost to consumers include Gresvik and Haare (2009) for Norway, and Danmarks Nationalbank (2012), Turján et al (2011) and Segendorf and Jansson (2012) for Denmark, Hungary and Sweden, respectively (as part of country-specific analyses of the data collected for the ECB study). This type of analysis relies on estimates of the number and value of transactions undertaken by consumers and the time taken to conduct these transactions to estimate the opportunity cost of payments activity. In line with these European studies and the Bank's 2007 study, the current study has collected cost data directly from financial institutions and merchants, and has estimated consumer costs based on estimates of the time that consumers take to make payments. Therefore, consumer cost estimates are less robust than estimates of financial institutions' and merchants' costs and are not included in the reported estimates of total resource costs for the economy. More details on the construction of these estimates can be found in Appendix C.

2.5 Payment Instruments

The particular payment instruments included in each cost study have been determined by their relative importance to that country's payments system. For example, cheques tend to be excluded from studies conducted by countries in which cheque use is low. Additionally, some studies focus solely on point-of-sale payments to the exclusion of billing and remote payments. Due to the wide variety of payment instruments used in Australia, this study's coverage is in line with the most inclusive overseas studies. In particular, this study considers the costs associated with cash, debit and credit cards, cheques, direct debit and BPAY payments.^[4] It also considers some of these individual payment methods in more detail, including the costs for different methods of cash withdrawal, as well as different types of card and remote payments.

Reflecting recent developments in the Australian payments landscape, the study also examines the costs of new products and new methods of authorisation and/or authenticating retail payments. Recent innovations have included:

• The transition from using the magnetic stripe on cards to using chips for the storage of card details and transmission of these details to the terminal.
• The introduction of contactless payments functionality, which allows the wireless transmission of card details.
• The move from signature authentication to PINs for American Express, Diners Club, MasterCard and Visa cards (eftpos has always been PIN-only). In addition, lower-value payments often no longer require PIN authentication.
• The increased issuance of dual-network debit cards by the major banks.
• An increase in the number of institutions offering companion American Express cards.

These innovations will have directly altered the costs of accepting and making payments. For instance, some of these developments will have directly affected terminal and tender time costs for merchants, while others will have altered card production and fraud costs for financial institutions. These innovations may also have indirectly altered costs by affecting both the economies of scale for system participants and potentially the nature of competition.

Footnotes

For more discussion on the benefits and limitations of cost studies for central banks, see Hayashi and Keeton (2012). [2]

Arango and Taylor (2008) is one exception, looking at the marginal costs of different payment methods for merchants in Canada, along with merchant perceptions of costs, reliability and risk. Another is the paper by Garcia-Swartz, Hahn and Layne-Farrar (2006), which looks at benefits and costs. [3]

The study also collected information on payments made through agency arrangements. Agencies handle payments on behalf of merchants. This can be electronically, such as PayPal, or physically, such as at Australia Post branches. Merchants directly incur low resource costs of a few cents per transaction when employing an agent. However, the agent can charge relatively high fees – often of up to 2 per cent of the transaction value – for providing this service. Market concentration prevents the disclosure of further results. [4]