Thursday, January 12, 2006

Credit Card Fees

  
The Wall Street Journal, 12 January 2006

Perhaps Dustin Hoffman's rich adviser had it right when he pronounced in "The Graduate" that the future is in "plastics." Last year the credit card industry handled more than $2 trillion in consumer transactions and gobbled up nearly $30 billion in fees, according to the Nilson Report newsletter on the credit card industry. These fees are now the source of mounting angst among retailers, which have launched 47 antitrust lawsuits against the credit card companies for alleged collusion in setting these fees.

Retailers have also rushed to Washington demanding that Congress impose a de facto price cap on credit card charges -- as Australia and the European Union have already done. This campaign against credit card fees and the clamor for price controls sound eerily familiar. A few years ago dim-witted politicians employed price controls to try to limit fees for using ATMs. In localities where that was tried, the result was not lower fees, but fewer ATMs, and thus much less convenience for customers.

Once upon a time, credit cards were the playthings of the rich. But today credit (and debit) cards are a ubiquitous feature of the U.S. economy, with three of four adults owning either credit or debit cards as America moves closer to becoming a "cashless society." Certainly the shift toward plastic payments suggests the industry is satisfying its customers.

The controversy surrounds the way Visa and MasterCard and their issuing banks make money -- which is by collecting what is called an "interchange fee" from merchants. This fee averages about 1.75% of the sales price of the good or service purchased. The average convenience store paid $31,000 in interchange fees in 2004 -- a figure approaching the average per-store pretax profit of $36,000. The retailers say this charge is a "hidden transaction tax on consumers."

This complaint ignores the value added that the credit card company provides. Consumers benefit in an obvious way: They don't have to carry around wads of cash, because the credit card bank essentially holds the funds for them. Retailers benefit too: They don't have to deal with cash transactions, which minimize theft at the cash register. They receive a guaranteed payment from the bank that issues the credit card (i.e., no bounced checks). Most importantly, they lure customers into their stores by accepting a credit card of choice. If the retailers didn't think these benefits exceeded the costs of the interchange fee, they could simply refuse to accept credit cards at the register.

That said, many small retailers operate on thin profit margins and there does appears to be some merit to their complaint that credit card fees have risen above the levels one would expect in a perfectly competitive market. Interchange fees in the U.S. are among the highest in the world.

These fees, according to a recent study by economists at the Federal Reserve Bank of Kansas City, have also been paradoxically trending upward in recent years when the industry's costs due to technology and economies of scale have been falling. But these rising interchange fees have also corresponded with lower annual fees charged to cardholders and increasingly lucrative incentive packages to entice shoppers to pay with plastic: cash back rewards, airline frequent flyer miles, and even exotic benefits like free "concierge service" to get tee times on the golf course.

We're all in favor of more competition to drive down interchange fees. But the argument retailers are making that this industry operates as a cartel is highly unpersuasive. There are five major competitors in the credit/debit card market aggressively vying for customers: Visa, MasterCard, American Express, Discover, and the newest player, Star.

Meanwhile, mega-retailers such as Wal-Mart and Sears are using their market power to cut separate deals with credit card companies to lower their interchange fees. Wal-Mart and Target also want to establish their own banks so they can reduce interchange fees. Federal regulators should welcome this development.

Another merchant recourse is to offer price discounts to customers who pay cash. Retailers could also band together and start their own credit card competitor to Visa and MasterCard. Antitrust laws have typically winced at this kind of relationship, but in this case the Justice Department should consider that such arrangements could lower costs to consumers and foster competition.

The worst option is the one retailers seek most fervently: price controls. We now have several years of evidence from Australia and other nations that have gone this route. Studies indicate that lower retail prices haven't materialized. Instead, retailers have mostly pocketed the savings, while Visa and other card companies have withdrawn the popular rebates and bonus awards while increasing the annual fees they charge to card holders.

In other words, consumers were the losers, which is what inevitably occurs when governments intervene in markets that aren't broken. That's why Congress and the courts should keep their paws off this industry and let the market give credit, where credit is due.
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