The interchange fee panel

By Felix Salmon
June 9, 2010
panel on interchange fees was a little bit frustrating, for me: there were lots of arguments, but everybody seemed to be talking past each other to a large degree. I particularly wanted to get into the argument, which was made by Todd Zywicki in his paper and also by Geoffrey Manne on the panel, that interchange fees were an important way of banks passing on credit losses to merchants. Here's the comment that Zywicki left on my blog:

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This morning’s panel on interchange fees was a little bit frustrating, for me: there were lots of arguments, but everybody seemed to be talking past each other to a large degree. I particularly wanted to get into the argument, which was made by Todd Zywicki in his paper and also by Geoffrey Manne on the panel, that interchange fees were an important way of banks passing on credit losses to merchants. Here’s the comment that Zywicki left on my blog:

I am not arguing that credit risk is overall a money-losing proposition for card issuers for exactly the reason you state–purchases is what generates a customer base for issuers. What I am arguing is that merchants want to argue that the only costs that matter are the marginal costs of processing transactions. That ignores the costs of credit risk. Once that variable is considered, with respect to credit cards, it is not obvious at all that merchants are being overcharged on interchange fees. For reasons discussed in the paper, merchants likely would have issued much of this credit in-house (or foregone sales) and would have suffered similar, and probably larger, credit losses.

My take is exactly the opposite: that the provision of credit is a source of profits, not of losses, and that talk of “credit losses” makes no sense without looking also at credit profits, in the form of fees and interest payments. It’s undoubtedly true that merchants get higher revenues as a result of their customers being able to buy things on credit. But it’s silly to say that the merchants are dodging losses insofar as those customers default on that credit: after all, no one accuses them of dodging profits insofar as other customers end up paying much more, over time, for their purchases than the merchant received, after factoring in those fees and interest payments.

I was also interested to hear a number of people try to make the case that interchange fees are rising because of the rising amount of fraud and identity theft. I haven’t seen much in the way of hard numbers on this front, but it does seem obvious to me that if banks were seriously worried about fraud and identity theft, they would lobby for the same EMV (or chip-and-PIN) system that most of the rest of the world uses, rather than relying on cards with magnetic stripes. The UN’s credit union has just started offering these cards to its customers in the U.S., probably because they tend to travel abroad so much. Why are the banks happier to suffer fraud losses and raise interchange fees to make up for them than they are to implement EMV? Because EMV would involve a cost, for them, while interchange fees are a significant profit center.

After the panel was over, a representative of CUNA, the credit union association, introduced himself to me. I asked him why CUNA was opposed to the Durbin amendment which places limits on interchange fees, even though it explicitly excludes 99% of credit unions; he said that it was simple, really. If the Durbin amendment goes through, then interchange fees are likely to come down across the board, and credit unions make lots of money from interchange fees.

And if credit unions make lots of money from interchange fees, you can only imagine what the big banks make: 15 large banks have almost 95% of the credit card market, where interchange fees are the highest. The fact is that the banks love interchange fees because they’re an easy and invisible way of providing billions of dollars in effort-free profit. So let’s hope that the Durbin amendment goes through, and starts to tilt matters in the other direction, moving those billions of dollars out of the hands of the banks and into the hands of merchants and consumers.


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You are absolutely correct that interchange fees are too high and that merchants are being largely riped off. I’m a banker and I agree with that.

I dissagree with two points… first interchange fees while lucrative are in no way “effort free.” When a large grocery store chain fell victem to a corporate criminal syndicate and roughly 1000 of our customers cards were comprimised we basically shut down our operations department to re-issue 1000 debit cards in two days. All that expence fell to the bank. Now that’s one incident in the 7 years I’ve worked at my high achiving local savings bank; so clearly we make money on interchange… just not effort free.

On the “credit” issue… your aquaitence may have been trying to contrast the divine assurance of receiving 96 cents on the dollar when being paid with a card, with the risk of accepting a paper check. If someone floats you a bad check you’re out of luck for the purchace price and probably hit with a $35 dollar fee from your bank as an added slap in the face. That’s whay so many businesses don’t even accept personal checks.

Think about this the next time you want to compare checks clearing at par with a 4-5% interchange fee:

Nearly all small merchants accept cards even with the profit margin destroying fees.

Many small merchants won’t accept personal checks even though they clear at par… why is that?

Keep up the great blogging… your content is FANTASTIC!

Posted by y2kurtus | Report as abusive

Paypal fees, on the other hand, are indeed almost effortless. Now that’s something to get really angry about.

Posted by MarshalN | Report as abusive

Like I said, zywicki is a pompous twit who only deals in red herrings and misdirections. Looking at his comment, “simply” is apparently a very important word to him, and it appears that he’s picked up on the fact that it often implies obviousness; but (as I’m sure you’re aware) the only thing it really proves is that zywicki is a very insecure fellow who feels the need to “subtly” bash others to feel good about himself. If this is what passes for a right-wing academic in the US, then Glenn Beck deserves an honorary PhD.
Anyway, the problem with these chaps, I’ve noted, is that they frequently present highly decontextualized, or just plain incorrect information, and then proceed to argue some point or other based on that.
Needless to say, regardless of their status as a tenured academic, it is best to assume they lie, as they aren’t trying to participate in intellectual debates; all they want is to ‘defend’ their hobby horses.

PS. As a rule of thumb, it is wise to assume any service a bank offers is profitable to them; the most important example to consider here is the fact that, on those mortgages, they made (and make!) oodles of interest money because people are reluctant to default on loans even when it makes no sense whatsoever for them not to do so.

Posted by Foppe | Report as abusive

(“those mortgages” being subprime mortgages as well as any others that are now under water)

Posted by Foppe | Report as abusive

Gotta love Zywicki’s intellectual dishonesty- He’s arguing that the merchants should assume “credit risk” because they’ve helped banks expand the bank’s profit center of credit. Nothing like getting charged to help another business make money.

Posted by AdamJ23 | Report as abusive

While domestic service is already expensive enough, merchants enrolled with (let’s say) Cardservice International get hit with more like 9% in VA/MC charges on transactions with Canadian and Mexican customers. It can quickly become a losing business for the retailer, on top of other usage fees they have to pay for the privilege of running a plastic terminal to keep shoppers happy.

So much for the logic behind NAFTA and international banking.

Posted by HBC | Report as abusive

Felix, I’d be interested in your take on letting merchants pass on the fee to purchasers. It does seem there is a monopoly and something should be done. But can’t we try letting millions of merchants and 100 of millions of customers make there own decisions on the appropriate fee before we appoint a regulator to decide it?

Posted by Mr.Do | Report as abusive

Mr. Do- Well, getting millions of merchants and 100 of millions of customers creates a bit of a collective action problem. One consumer who fights the credit card companies has to deal with cash and sees no apparent upside. One merchant who decides to fight the credit card companies by denying credit cards is going to get punished in the marketplace- other merchants in the same market will quickly scoop up that merchant’s credit card using customers. The same goes for creating a transparent fee for using credit cards- a credit card using customer will go to a merchant who doesn’t have a transparent fee, because he can get it cheaper by free riding and sharing the fee with non-credit card using customers. You either need the merchants to collectively bargain with the credit card companies on fees (so they have roughly equivalent bargaining power) or you need regulation. And I suspect collective bargaining isn’t feasible (or legal for antitrust reasons) but it would probably create a more fair bargain then regulation.

Posted by AdamJ23 | Report as abusive