Now that we have the second Payment Services Directive going live in a couple of jurisdictions, the news media are reporting on one of its prominent features: the retailers do not have the right to pass on payment fees to consumers for all cards that are subject to the EU regulation on multilateral interchange fees (MIFs).
As can be seen in the tweet below, the UK chose to extend this to 3 party schemes as well.
As I expect quite some further discussions on this topic (and retailers circumventing the rules by introducing other types of charges to their customers) I figured it would be good to provide some background on the reasoning that is occuring in the area of MIF-regulations. A further look at history would even suggest that we need to take one step further back in order to rethink our analysis so far.
Some background on MIF-modelling (and subsequent regulation)
If we try to assess the arguments pro and con interchange fees, some important thinking in this area is done by
Nobel prize winner Jean Tirole, who worked
together with Rochet on competition in two-sided markets, such as
payment-cards markets. At the heart of their studies is the question what the pricing structures are in two-sided markets and under which conditions and to which extend compensation payments between different sides of the market (interchange fees) are justified.
This work has been at the core of many regulatory strategies but it is subject to a lot of discussion. All market players, whether 3 or 4 party card schemes, issuing banks, acquirers, processors, retailers, consumers and
regulators, heavily debate pro's and con's of interchange fees. And in doing so they must use the reasoning and models of Rochet and Tirol. In essence the model tries to determine which cost and interchange fee levels are relevant for competing products/platforms such as cards vs cash.
Do note however that already more than 10 years ago, Brookings Institution released a
very good paper on interchange fees, concluding that
it is impossible to prove one or the other side of the arguments on interchange fees, let alone determine which level of interchange fee is correct. I think their analysis still stands which means that in the end, interchange fee regulation is more about lobbying and power politics than actual econometric calculations.
Europe's reality under PSD2 and MIF regulation
What is happening under the current payments regulation in Europe, is that:
- a maximum cap is defined for the interchange fee of credit-card and debit-card transactions (reducing the cost to the retailer),
- retailers are forbidden to surcharge for payment costs, when the customer uses a card which has a capped interchange fee (reason being that they may not gain from reduced costs on the one hand while keeping surcharging intact on the other hand).
In essence this means that the EU has bought into the argument that multilaterial interchange fees were being set to high and require regulatory intervention (thus emulating the behaviour of other regulators such as the FED and Australian Reserve Bank). In doing so they accept and embrace academic models which mostly focus on the topic of optimal price regulation in a stationary market with alternative platorms/products.
Historic approach: where did the interchange fee come from in practice?
It strikes me that all the economists at play use an empirical description and mathematic approach to start their reflections on interchange fees. One very obvious element is missing in a lot of papers (
except Baxter, who goes at length to discuss history): what were the market players thinking when they wanted to introduce these fees? What is the industry trade-off they are facing?
In Dutch payment history, the banks have been very keen not to disclose their cost/benefit considerations and finances. It was only in 2005 that they allowed McKinsey - as a notary - to have a full look at all internal costs and benefits, in order to
draw up a report on costs/benefits based on a full insiders view. I have been personally committed to this effort and helped making it become a reality based on the belief that a lot of misconceptions can be eliminated by being open on ones business model.
However, while this report shows the situation in 2005, it doesn't tell us where the interbank fees came from. The archives of banks do however and to me it is stunning that very few academics in the interchange fee domain have tried to uncover these sources to calibrate their reasoning. Because if they would, they might be able to enrich their analytical approach.
Core question: can we avoid double charging for the retail customer ?
Reading through the old reports of collective groups of players in the Dutch payments domain, we can see an interesting game-theoretic approach to the multilateral fee discussion (which I will be disclosing more in detail in
an upcoming publication on the history of Dutch retail payments).
In essence, in the 1980s the emergence of new players, that were going to be piggy backing on an existing infrastructure without interbank compensation, fueled an existing debate on the distortion of the cost/benefits of banks. Banks with a lot of private consumers would usually bear many processing costs, while banks with corporate customers would reap the benefits. And the winner in the game would be new players, for example investment funds, that would hold pooled accounts for customers funds at a large bank, without having to pay anything for the incoming deposits that came from all the Dutch banks.
Setting an interchange fee in this context leads to:
- a more appropriate allocation and compensation of payment costs along the payments value chain: the entity that benefits from a payment will also bear part of the originating cost,
- the elimination of free-riders in the system,
- interbank understanding that consumers would not be levied fees for instruments where an interchange fee arrangement existed.
The explicit reasoning in a well documented cost/benefit study here in the Netherlands (never officially published as banks made sure to not disclose their thinking) was that it was of course also possible to not introduce an interchange fee system. The involved payment experts noted however that this would lead to bank fees on both the consumer and corporate side of the market. Absent coordination and agreement of reasonable interchange fees, the expectation was that those individual fees of banks to their respective customers would be higher than necessary.
In addition, the bankers expected the corporate side of the market to also add on surcharges and administrative charges to the consumer, which meant that effectively the consumer would then pay twice for payments processing costs: one time at the issuing bank and the other time at the retailer/corporation side, where the payments costs were incorporated into the price of services. Thus, for the Dutch society as a whole, this situation with mark ups on payment processing costs starting at the bank individual level, would undoubtedly be more costly, than the situation where the bank layer coordinates its cost/fee level and thereby avoids double charging of the customer.
The EU-choice revisited: higher payment costs as unintended side-effects of the MIF-regulation
It is clear that the EU perspective on interchange fees is:
- we don't trust the diverging interests of banks and competing card schemes in combination with competition to lead to an appropriate level of interchange fees, so we set an interchange level by ourselves,
- we also don't trust merchants and want to avoid them pocketing the benefits of lower interchange fees at the costs of consumers.
In practice we may now see in Europe that:
- issuing banks have shifted their income base and costs to consumers are increasing,
- acquiring banks will use other fee mechanisms to charge the retailer for the relevant payment costs in the card chain (as long as it exists as such, because a move to instant sepa credit transfers looks pretty enticing of course),
- retailers will use other fee mechanisms or labels (service charges) to charge the consumers for payments,
- consumers are paying higher fees to their issuing bank,
- consumers will effectively be paying twice for the relevant payment costs, in spite of the EU goal that they don't.
Where Europe has chose to intervene in interbanc dynamics, in order to achieve the best result for society, I am not sure if this will indeed work out as such. Yet, I must confess I am not an academic scholar in MIF-models and I get dizzy when reading all the equasions. However, I sense that some of the MIF-modelling doesn't match the actual game-theoretic constellation that occurs in practice.
Personally, I would rather place my trust in the diverging conflicts of interests between closely collaborating banks in an industry (leading to an interchange fee level that is scrutinised among quarreling bank experts) to keeping my payment costs appropriately low, than the good intentions of regulators that expand their interventions towards those mechanics themselves (thereby unleashing the possibility of double charging to me).
