Wednesday, March 15, 2006

Apportioning credit on card reforms

An article in The Age today reports on a Conference on Payment Systems held at Melbourne Business School, yesterday. Here is a link to the conference site. From the article, one would get the impression that the Reserve Bank was under fire over those reforms with hard hitting criticism coming from all quarters.

I was there and spoke at the conference and that wasn't my impression at all. In 2003, Australia enacted a set of reforms to the credit card system that from a regulatory standpoint, were dramatic. Prohibitions on surcharges for credit card transactions were removed, access to card schemes opened up and, most critically, the interchange fee -- the fee that banks pay each other to settle card transactions -- was cut by one half. The last change was significant. Not only was this industry now subject to price regulation but a sharp change in a key price. Now central banks enact sharp changes all of the time in interest rates but for regulatory price setting (e.g., by the ACCC) this kind of thing is unheard of.

The article gives the impression that the predicted massive disruption to industry actually ensued. But that is hardly the case. Dramatic reform has appeared to add up to dramatic non-reaction. Without going into too much detail but according to the Reserve Bank's own figures, credit card usage (by value or number) has continued to grow at historic rates, credit card debt has grown along with it and the share of credit card use to EFTPOS use has remained roughly constant. Take a look at this graph:

This last point is significant as The Age article suggested that in fact EFTPOS was rising at the expense of credit cards. But this has only occurred in the last quarter; 3 years after the reforms. For all we know it is just a statistical blip.

The most that might be said for dramatic change is that it is still to come. Professor Jean-Charles Rochet (speaking at the conference and one of the most influential academics in this area) raised this possibility; especially considering the long-run effects on investment. What the reforms have potentially done is shifted profits from card issuers (who deal with cardholders) to card acquirers (who deal with merchants). In this case, issuers will have a reduced incentive to invest in the system while acquirers will have a greater incentive. Rochet's point is that we don't know if this is a good thing or not and so should have been more cautious about regulatory intervention.

In my opinion, there is less to be concerned about in the long-run than industry participants are making out. Specifically, the interchange fee is but one means that banks might use to share costs of mutually beneficial investments. They need not use this at all and simply agree to alternative funding arrangements. Moreover, these would not be built into the cost of each transaction and would be instead based on forecast profits and the like; just as normal businesses do everyday. That should not deter investment that would assist the credit card system.

It seems to me that the main risk comes from taking the regulatory interventions here too seriously. There are some many other alternatives that this one price just doesn't really matter. What matters is regulatory uncertainty. Everytime that price is changed, there are consequences and costs on market participants. So uncertainty about whether it is going to change or not will have a 'chilling' effect on activity and arriving at mutually beneficial arrangements. Some of this uncertainty comes from continuing RBA reviews. Other uncertainty comes from legal action lauched in relation to those reviews. It would be better if regulators and participants could regulate the interchange fee and just move on.

Indeed, for 20 years, the banks themselves practiced this. At the beginning of the establishment of the BankCard system, the banks set the interchange fee at a nice round number. They then didn't do anything more until the RBA and ACCC started sniffing around. The very rigidity tells me that the fee is not important as an instrument for changing circumstances; large scale change occurred anyway over this period. What we want to do is return to rigidity.

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