The "interchange fee" (sometimes called the "swipe fee") is an element of the price a merchant pays when a consumer uses a credit card for a purchase. Interchange partially compensates the cardholder's bank for the cost and risk of offering payment cards to consumers. This includes clearing costs, billing and collection, fraud recovery, customer service, credit losses, and the resolution of any disputes that might arise from the transaction.
Credit cards generate three basic revenue streams: finance charges, merchant fees, and behavior-based fees such as penalties for late payment. Because annual fees have largely disappeared on standard credit cards, interchange is generally the only compensation issuers receive for the billions of dollars of credit they make available to consumers who pay their balance off every month. Credit unions and community banks, which cater to lower-risk customers who are less prone to revolve balances and pay penalty fees, rely especially heavily on interchange revenues.
Merchants pay, on average, less than 2% of the transaction amount in interchange fees. In exchange, merchants are relieved of the cost and risk associated with running their own in-house credit operations. And they benefit because consumers can make purchases even when they don't have enough cash in their wallets. This deal is voluntarily assumed by merchants who agree to accept payment cards because the benefits exceed these costs.
But now the Merchants Payments Coalition—a group of retailers, supermarkets, drug stores, convenience stores, gas stations, on-line merchants and other businesses—wants Congress to intervene to rewrite their contracts. Several legislative proposals are on the table and while they differ in their details, they are identical in their intent—to artificially reduce interchange prices.
What would happen if the Merchants Payments Coalition gets its way and politicians squeeze interchange fees? Credit cards are essentially a closed economic system: A reduction in interchange fees will have to be offset by increased revenues elsewhere or a reduction in costs. For example, issuers could try to increase the revenue generated from consumers through higher interest payments, higher penalty fees, or reinstating annual fees.
Card issuers might also reduce the quantity and quality of credit cards by restricting credit availability and cutting back on product innovation or ancillary card benefits. This is exactly what happened when Australian regulators imposed price controls on interchange fees in 2003: Annual fees increased an average of 22% on standard credit cards and annual fees for rewards cards increased by 47%-77%. Card issuers also reduced the generosity of their reward programs by 23%. Innovation, especially in terms of improved security and identity-theft protection, was stalled. Card issuers also increased their efforts to attract higher-risk customers who generate interest and penalty fees to offset lower interchange revenues from lower-risk transactional users.
The most important pro-consumer innovation in payment systems of the past two decades has been the general disappearance of annual fees on most credit cards. Cardholders now carry and use multiple cards at little or no cost. The consequences for consumer choice and competition have been profound—card issuers compete for consumer business literally every time they open their wallet to make a purchase.
Annual fees are essentially a tax on card-holding. Policies that produced a return of annual fees would strangle this process of competition by making it more expensive for consumers to hold multiple cards and to switch cards easily. Small businesses, three-quarters of which rely on credit cards, would also have to pay more to maintain access to multiple credit lines, stifling the most potent engine of economic recovery.
Discouraging credit card use would also slow the evolution from a paper-based payment system to a more efficient electronic system. In 2009 the Federal Reserve budgeted $600 million just to print currency (excluding coins). This doesn't even consider the deadweight costs to the economy of cash, such as the time consumers spend making ATM transactions, the cost of paying armed guards to drive around pieces of paper in armored cars, increased crime and tax evasion, or the time spent waiting in the checkout line behind check-writers. Checks are so inefficient that British banks have announced a plan to phase out their use by 2018.
Critics object that interchange fees impose costs on merchants and force cash purchasers to pay more for goods and services to subsidize credit card users. But there is no evidence that Australia's cap on interchange fees resulted in lower prices for consumers. When allowed to charge credit card users, some Australian merchants imposed surcharges that exceeded the costs incurred and expressly refused to reduce prices for noncredit purchasers.
A November report by the Government Accountability Office concluded that any potential intervention could produce severe unintended consequences and major implementation challenges. Indeed, Australian regulators are facing demands for another round of interventions to address the effects of the prior round, such as to limit retailers' surcharge practices.
Merchants also contend that the current regime forces cash purchasers to subsidize credit card users through higher prices. But federal law expressly permits merchants to give cash discounts (and some do). Moreover, cross-subsidies are ubiquitous in the economy. Newspaper advertisers subsidize readers, and Starbucks' customers who drink their coffee black subsidize those who use cream and sugar. Consumers who pay full price subsidize those who buy the same product on sale, and free parking benefits drivers but not bus riders.
There is no free lunch for interchange fees or anywhere else. But if groups like the Merchants Payments Coalition have their way, consumers may soon find their lunch more expensive if they pay with a credit card.
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