The Symmetry of the Interchange Debate

[Timothy B. Lee] 4420214662_05d6ab997c.jpg

In his Forbes column, my friend Reihan Salam examines the debate over credit card interchange fees, which are paid by merchants to credit card networks. These rates have historically been in the range of 1 to 2 percent, and the revenues are passed along to card-issuing banks.

Two companies, Visa and MasterCard, run the credit card networks that dominate the market. Consumers have come to expect that merchants will accept these cards, which gives the operators of these networks tremendous leverage. This has allowed Visa and Mastercard to steadily raise fees, as Mike Konczal illustrates. And, the argument goes, these fees ultimately translate into higher prices at the cash register. Reihan reluctantly concludes that regulation of interchange fees is needed. I'm not so convinced.

The problem with this argument, as Todd Zywicki points out in a recent paper, is that it ignores the two-sided nature of the credit card market. The argument over interchange fees has largely focused on the merchants' side of the equation. But this ignores the banks' side of the market, which is just as important for overall consumer welfare.

In particular, hardly anyone in the interchange debate has paid much attention to the generosity of cardholder benefits programs. For example, I currently have a credit card from Chase that offers me 1 percent cash back on every purchase I make, with no gimmicks or strings attached. Perhaps even more impressive is the seemingly perpetual availability of 12-month, interest-free loans. [Clarifying edit: these are separate offers from other banks, not another feature of the Chase card. And they're on purchases, not balance transfers.]  I was skeptical of such offers when I first started getting them, but I've now used them a few times and there doesn't seem to be a catch. I'm not sure exactly how to value a 1-year, 0 percent loan, but it's easily worth more than 1 percent of the amount borrowed.

Most of the commentary on interchange fees have focused on the rate paid by merchants, but this is the wrong number to focus on. Rather, we should care about the net of merchant fees minus cardholder benefits. If credit card fees rise but benefits rise by an equal amount, the result is a wash as far as the customer is concerned. I'm not aware of any precise data on cardholder benefits, but judging from the fact that companies used to charge an annual fee to issue credit cards and they now frequently offer generous cash back, I think it's safe to say that benefits have gotten more generous over time. So looking only at interchange fees gives us a distorted picture.

Now maybe you don't believe that banks will continue to pass increased fee revenues on to their customers. But notice that this is a symmetrical situation. If you doubt that competition among banks will shift most of the benefits of higher fees to consumers, then you should be equally skeptical of claims that competition among merchants will translate lower credit card fees into lower retail prices.

Konczal writes derisively about cardholder benefits, arguing that merchants "don't want to subsidize the airline industry by having to pay for rich people's frequent flyer miles reward card for free, without anything in exchange for providing an additional good or service." But this misses the point in a couple of important ways. First, the benefits are limited neither to frequent flyer miles nor to rich people. But more fundamentally, what merchants want is irrelevant, because there's no reason to think consumers' interests are more aligned with merchants than with banks. Indeed, you could view the credit-card-issuing banks as agents for cardholders, negotiating for discounts that are passed along to their customers.

Advocates of regulation like to tell a populist story of consumers against rapacious banks. But there are wealthy corporations on both sides of the bank-merchant relationship. There's no reason for regulators to side with Wal-Mart over Wells Fargo. Policymakers should focus on ensuring that both sides of the market (card-issuing banks and card-accepting merchants) are robustly competitive. Then consumers will reap most of the benefits whether interchange fees go up or down.