© Reserve Bank of Australia 2001. All rights reserved.  The contents of this publication shall not be reproduced, sold or distributed without the prior consent of the Reserve Bank of Australia.  ISBN 0-642-50172-6

1. The credit card network in Australia is extremely well developed and credit

cards are used for a wide variety of transactions. Over the past decade, the

number of credit card transactions has risen four-fold; credit cards overtook

debit cards (EFTPOS) in 1999 as the main non-cash means of payment. Credit

cards are now widely used purely as a payment instrument by cardholders

who settle their credit card account in full each time and do not use the

“revolving” line of credit.

2. For cardholders, credit cards provide a range of services. They are convenient

and widely accepted, both in Australia and abroad. Most provide an

interest-free period that allows cardholders a month or more in which to

arrange settlement of their credit card purchases. They also provide a

guaranteed refund to cardholders when goods or services purchased with

credit cards are not delivered. Cardholders who make use of the revolving

line of credit are able to buy goods and services earlier than their incomes

would otherwise permit.

3. For individual merchants, credit card acceptance forms part of their

competitive strategy of attracting sales from, or not losing sales to, rival

merchants. Indeed, credit card use has become so widespread that most

merchants believe they have no choice but to accept credit cards. Credit cards,

like cash and debit cards (EFTPOS), provide merchants a guarantee of payment,

unlike a cheque which might be subsequently dishonoured.

4. Credit card services are more costly to provide than most other payment

instruments. Credit card issuers incur processing costs for each transaction,

funding costs in providing credit – whether the interest-free period or the

revolving line of credit – and costs of fraud and credit delinquencies. Credit

card acquirers – the financial institutions that provide services to merchants –

also incur processing and fraud costs and must meet refund obligations if

goods and services purchased with credit cards are not delivered.

5. Someone must ultimately meet these costs. Two groups do so in Australia, at

least in the first instance. One group are those cardholders who use the

revolving line of credit, who pay interest rates significantly above rates on

other forms of unsecured lending. The other group are merchants, which

pay an average of 1.8 per cent of the value of each credit card transaction –

and as much as four per cent in the case of small merchants – in merchant

ii

service fees to their acquirers. Like other business inputs, these costs have to

be covered by merchants, so they are passed onto all their customers, not

just those who use credit cards, in the form of higher prices for goods and

services. In this way, the costs of providing credit card services are ultimately

borne by the community as a whole. Prices paid by users of lower-cost

payment instruments are higher than would otherwise be the case, while

prices paid by credit cardholders are lower than they would be if cardholders

faced the costs of the credit card services they used. Within the latter group,

there is a third group which directly contributes very little to the costs of

credit card schemes – these are the cardholders (known as “transactors”) who

settle their credit card account in full each month. Although they normally

pay an annual fee, they pay no transactions fees, enjoy the benefit of an

interest-free period and in many cases earn loyalty points for each transaction.

6. It is not surprising that credit card usage in Australia has increased strongly

in recent years in view of the price incentives facing consumers. Consumers

using a debit card (EFTPOS) pay a fee to their financial institution (beyond a

fee-free threshold) for accessing their own funds; “transactors” using a credit

card pay nothing, and may be paid in the form of loyalty points, for using

the funds of their financial institution. Nor is it surprising that banks and

other deposit-taking institutions are promoting most actively the credit card

because it is the payment instrument for which they receive the highest return,

and yet it is one of the most expensive for merchants to accept.

7. This unusual structure of incentives is not the result of normal competitive

processes. It is the consequence of the regulatory framework established by

the credit card schemes and the fact that it is the same group of banks and

other deposit-taking institutions that sets the fee structures for credit cards

and the other main payment instruments in Australia.

8. The major credit card schemes in Australia have a set of regulations, which

their Australian members collectively determine or agree to enforce, that:

(i) set the wholesale fees (known as “interchange fees”) that are paid to the

issuer by the acquirer whenever a merchant accepts a credit card for payment;

(ii) in the case of MasterCard and Visa, prevent merchants recovering from

cardholders the cost of accepting credit cards; and

iii

(iii) restrict membership of the schemes, broadly speaking, to authorised

deposit-taking institutions supervised by the Australian Prudential

Regulation Authority (APRA).

This regulatory structure is unique in Australia; a comparable set of restrictions

has not been permitted in any other market without authorisation under the

9. These credit card scheme regulations have become the focus of closer public

scrutiny in recent years, in Australia and elsewhere. The Financial System

Inquiry (the Wallis Committee) highlighted interchange fee arrangements

and restrictions on access to credit card schemes as areas of policy concern.

In response, the Payments System Board of the Reserve Bank and the Australian

Competition and Consumer Commission (ACCC) undertook and published

(in October 2000) a detailed study of debit and credit card schemes in

Australia, which concluded that Australia has a higher cost retail payments

system than necessary, and that much of this cost is borne by consumers

who do not use credit cards. The legal status of interchange fee arrangements

10. Against the background set out in Chapter 1 of the consultation document,

the Reserve Bank formally brought the Bankcard, MasterCard and Visa credit

card schemes in Australia under its regulatory ambit in April 2001. Since

then, it has consulted with a broad range of interested parties about whether

the regulations established by the credit card schemes are in the public interest.

The Reserve Bank’s involvement is in fulfilment of the Payments System Board’s

mandate to promote efficiency and competition in the Australian payments

system, consistent with overall financial stability.

11. The normal competitive processes that drive markets ensure that consumers

respond to efficient price signals and that resources are free to move to exploit

profit opportunities. The community’s welfare is enhanced as a consequence.

Credit card scheme regulations have the effect of suppressing some of these

processes. Nonetheless, the credit card schemes and their members have argued

that the regulations are essential for the growth of credit card networks and,

thereby, for community welfare.

12. Interchange fees in credit card schemes play a pivotal role in determining

the incentives for consumers to use, and merchants to accept, credit cards.

iv

Interchange fees are a type of transfer payment that enables credit card issuers

to recover some of their costs from acquirers and, in turn, from merchants

through the merchant service fee. Revenues from interchange fees allow credit

card issuers to “subsidise” cardholders to use their credit cards, by charging

them less than the cost of the credit card payment services they use or even

offering rebates in the form of loyalty points. The burden of this subsidy falls

initially on merchants, which are charged more than the costs incurred by

their acquirers, but it ultimately falls on the community as a whole through

higher prices for goods and services in general.

13. In the consultation process, the Reserve Bank has addressed two particular

questions about interchange fee arrangements in Australia:

(i) what is the need for interchange fees in credit card networks; and

(ii) will card scheme members acting in their own self-interest collectively

set the “right” interchange fees from the community’s perspective.

14. The subsidy to credit cardholders through the interchange fee has been

defended on the basis that cardholders would not use their credit cards if

they faced issuers’ full costs; merchants would therefore be denied the full

benefits of participating in credit card schemes. The subsidy, it is claimed, is

needed to ensure that credit card networks reach their optimum size and

deliver maximum benefits to cardholders and merchants. These arguments

are carefully examined in Chapter 2 of the consultation document. It concludes

that, while there may be a case for issuers to pass some of their costs onto

merchants through interchange fees, there is presently no “science” in

determining the level of such fees.

15. Credit card schemes and their members have also argued that interchange

fees set collectively are efficient for the community as well as for the schemes.

Their claim is that competition between credit card schemes, and between

credit cards and other payment instruments, prevents interchange fees going

too high or too low. There is no strong support for this argument in the

emerging economic literature in this area, while the practical counter is the

reality of interchange fee setting in Australia. Interchange fees have been rigid –

rates have not changed at all in 27 years in the Bankcard scheme and only

once in the past decade in the MasterCard and Visa schemes (when, in the

latter case, they rose) – and the fee-setting process itself has lacked transparency

and any objective benchmarks. The “checks and balances” that would be

provided if there were robust competition in the payments system do not

seem to have operated. Overlapping governance arrangements mean that the

v

four major banks dominate the credit card schemes in Australia and are also

the main providers of competing payment instruments; because there are no

other large credit card acquirers, merchants have not had a strong and

independent voice in interchange fee setting. This environment provides no

assurance that the current level of interchange fees passed onto merchants,

and ultimately onto the community, is in the community’s interest. When

merchants have limited ability to resist credit cards, the risk is that interchange

fees can be pushed above the efficient level, allowing issuers to further

subsidise credit cardholders and resulting in the overprovision of credit card

services and underprovision of alternative payments instruments.

16. Restrictions on merchant pricing imposed by MasterCard and Visa prevent

merchants recovering from cardholders the costs of accepting these credit

cards. Merchants therefore have an “all or nothing” choice in accepting credit

cards and no alternative but to recover their credit card costs by passing them

through to all their customers in the form of higher prices of goods and

services. These restrictions are defended as the means of preserving the subsidy

to credit cardholders made possible by interchange fee revenues. The claim is

that merchants as a whole would be denied the full benefits of participating

in credit card schemes if the subsidy to credit cardholders were unwound at

the till. Although this claim is made by the card schemes on behalf of

merchants, merchants themselves have argued strongly against the restrictions.

17. Arguments for restrictions on merchant pricing are weighed, in Chapter 3 of

the consultation document, against the adverse consequences of these

restrictions. Restrictions on merchant pricing are a restraint on trade. Card

scheme members are free to provide incentives to their customers with a

view to maximising their profits, but collectively deny merchants the same

opportunity. For consumers who do not use credit cards, the restrictions are

harmful because such consumers pay higher prices for goods and services

than they would otherwise; in this way, they contribute indirectly to the costs

of the credit card schemes. Because credit cardholders are using what appears

to them to be a free payments service, the price signals that normally guide

markets to an efficient use of resources are suppressed.

18. Credit card schemes impose minimum entry standards that are intended to

ensure the safety of the schemes. Broadly speaking, only authorised

vi (top of page)

deposit-taking institutions supervised by APRA are eligible for membership.

The card schemes also prevent their members specialising in credit card

acquiring, or impose financial penalties on members whose main activity is

acquiring, in the interests of “balanced development” of the schemes. The

arguments for restrictions on entry to credit card schemes are analysed in

Chapter 4 of the consultation document.

19. The Reserve Bank acknowledges that some minimum entry standards can be

justified because credit card issuing and acquiring does generate risks. Issuers

need to assess the creditworthiness of cardholders and settle transactions with

acquirers. Acquirers need to assess the creditworthiness of merchants and,

under card scheme rules, finance refunds to cardholders if goods or services

purchased with a credit card are not delivered. The failure of any one card

scheme member to manage its risks becomes an exposure for all other

members because of loss-sharing arrangements in each scheme.

20. Reliance on prudential supervision by APRA may provide a cost-effective and

objective screening device to determine eligibility for membership. In seeking

to promote safety, however, scheme restrictions deny access to non-financial

institutions that may have the skills, financial substance and distribution

networks to become effective competitors in the credit card market. The

exclusion of such institutions was a particular concern to the Financial System

Inquiry. Experience suggests that long-term incumbents in a market may not

provide the spark for more intense competition – new entry was the key, for

example, to more competitive pricing in the residential mortgage market in

Australia. The additional scheme restrictions on credit card acquiring in the

interests of “balanced development” are particularly difficult to defend in a

market that, on a number of indicators, needs a spur to competition.

21. Having weighed a range of arguments from interested parties, the Reserve

Bank is of the opinion that the main regulations established by the credit

card schemes in Australia do not meet the public interest test.  The regulations

suppress or distort the normal market mechanisms in ways that work against,

rather than contribute to, the community’s welfare. The pricing of credit card

services is sending consumers a quite misleading signal about the cost to the

community of different payment instruments, while barriers to entry are

quarantining the credit card schemes from the competitive pressures that nonfinancial

institutions of substance could bring to bear. Overall, the community

is paying a higher cost for its retail payments system than is necessary.

22. The Reserve Bank is therefore proposing a reform of credit card schemes that

will promote efficiency and competition in the Australian payments system.

Although it is using its payments system powers for this purpose, the Reserve

Bank is not adding a further layer of regulation to the credit card market; on

the contrary, the reform measures, taken together, will ensure that where

competitive forces have not been allowed to work, they will now be better

able to do so. The reform measures involve:

(i) an objective, transparent and cost-based methodology for determining interchange fees;

(ii) freedom for merchants to recover from cardholders the costs of accepting credit cards; and

(iii) a more liberal access regime that allows for the entry of specialist credit

card service providers, both issuers and acquirers, to be supervised by APRA.

These reform measures, which have been endorsed by the Payments System

Board of the Reserve Bank, are in line with changes that have been introduced

or are contemplated in other countries in which credit card scheme regulations

have come under scrutiny.

23. The Reserve Bank’s reform measures deal only with the regulations of the

credit card schemes governing the collective setting of wholesale fees, entry

to the schemes and restrictions on merchant pricing. The measures do not

deal with the relationships between individual scheme members and their

customers which are not covered by scheme regulations. Hence, they do not

cover the setting of credit card fees and charges to cardholders and merchants,

or interest rates on credit card borrowings.

24. The Reserve Bank acknowledges that interchange fees can have a role in credit

card schemes, as a means of enabling issuers to recover the costs of providing

specific credit card payment services that are of benefit to merchants. The

Reserve Bank’s draft standard provides an objective and transparent method

for determining interchange fees. The credit card schemes and Australian banks

have proposed a much wider range of costs for inclusion in interchange fees,

but without convincing explanations of why these costs should be passed to

merchants. Some of these other costs are proprietary matters between

individual card issuers and their cardholders and are not intrinsic to credit

card schemes, while the inclusion of costs such as credit losses would involve

an element of double-counting since these costs are already being recovered

in credit card interest rates.

vii

25. The draft standard requires that credit card schemes publish their interchange

fees and the aggregate costs that have been included. This will ensure that the

calculation of interchange fees is entirely transparent and can be readily

understood by card scheme members, the merchants to which the interchange

fees are passed, and the community. Identifying the specific costs involved

will also give card scheme members and merchants an incentive to address these costs.

26. In the Reserve Bank’s opinion, scheme restrictions on merchant pricing are a

source of serious inefficiencies in the pricing of payment instruments. In no

other market can a small number of institutions dominating the provision of

a widely-used product seek to promote that product over others by preventing

merchants charging its costs to their customers. The Reserve Bank’s draft

standard, which follows a decade of official concerns about these particular

restrictions, is straightforward. It prevents credit card schemes and their

members from preventing merchants recovering from cardholders the costs

of accepting credit cards. Whether merchants avail themselves of the freedom

to recover these costs will be for their commercial judgment.

27. Though some minimum entry standards are appropriate, the Reserve Bank

believes that the current barriers to entry to the credit card schemes unduly

restrict competition. The Reserve Bank’s draft access regime liberalises access

to the credit card schemes by allowing non-financial institutions of substance

to enter the credit card market in their own right. Such institutions will need

to be authorised and supervised by APRA. They will need to demonstrate to

APRA that they have the skills, staffing and operational capacity for the scale

of credit card activity proposed, and will have to meet ongoing prudential

standards no less strict than those currently imposed by APRA for given types

of risks. The draft access regime will make credit card issuing and acquiring

open to greater competition, without undermining the comfort from having

credit card scheme members prudentially supervised or the benefits to the

credit card schemes of “outsourcing” membership eligibility to APRA.

ix

28. The draft access regime specifically prohibits any card scheme restrictions or

financial penalties on members that wish to specialise in credit card acquiring.

These restrictions have no basis in risk management and, whatever their

original rationale, have the effect of handicapping potential competitors.

29. The Reserve Bank’s proposed standards and access regime will apply to the

three designated credit card schemes, Bankcard, MasterCard and Visa. The

“three party” card schemes – American Express and Diners Club – do not

have collectively set interchange fees nor restrictions on entry enforced by

existing members, and the Reserve Bank saw no case on public interest

grounds to designate these schemes to deal with these issues. However,

American Express and Diners Club do impose restrictions on the freedom of

merchants to recover credit and charge card costs from their cardholders.

The Reserve Bank will be consulting these schemes as to why they should

not also be required to meet the standard on merchant pricing.

30. The proposed reform measures will promote greater efficiency, transparency

and competition in the Australian payments system, to the benefit of the

community as a whole, while leaving the basic structure of credit card schemes

intact. The draft standard on interchange fees is likely to result in a significant

reduction in bank fees; in this instance the initial beneficiaries will be

merchants that accept credit cards, but the reduction will pass through to all

consumers in the form of prices of final goods and services that will be lower

than they otherwise would be. Over time, the freedom of merchants to recover

their credit card costs from cardholders and the possible entry of new types

of credit card service providers will strengthen the workings of competition.

Of course, reform will have a direct impact on credit cardholders and the

current subsidy they receive, although it will be a matter for individual card

issuers, in competition with other issuers, to determine how they will price

their credit card services to customers. That is the market mechanism at work.

Objections to reform of the designated credit card schemes – that it would

give a “free kick” to the relatively small, higher cost three party schemes or

that gains to merchants would not be passed onto consumers – are, at their

heart, a vote of no confidence in the competitive process in Australia. This is

a view that the Reserve Bank does not share.

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1

Australia has world-class debit card (EFTPOS) and credit card payment networks

which, over recent years, have become the main means, other than cash, by which

Australians make their payments. Debit and credit card transactions currently

account for around 45 per cent of the number of non-cash payments, almost

trebling their share over the past decade and displacing traditional payment

instruments, particularly cheques, in the process (Table 1.1).

per cent, May 2001

Cheques 21

Credit cards 24

Debit cards 21

Direct entry credits 25

Direct entry debits 9

Source: Australian Payments Clearing Association.

Card-based instruments enable payments to be made by transferring funds between

the cardholder and the recipient across the books of financial institutions. A debit

card (commonly known as EFTPOS) is a method of accessing a transaction account

held with a financial institution; the cardholder has funds taken from that account

at the time the card is used to make a transaction. Such accounts may include an

overdraft limit, but that is a separate decision for the financial institution and use

of the overdraft is paid for separately by the cardholder. A debit card as such

provides a pure payment service.

By comparison, a credit card provides a payment service and a credit facility. The

latter usually involves an interest-free period before the account needs to be settled

and a pre-approved line of credit, also known as a “revolving” line of credit, on

which users pay a rate of interest. The cardholder pays their credit card account

some time after the card is used to make a transaction, according to an established billing cycle.

2

The strong growth in popularity of card-based instruments nonetheless masks some

divergent trends in the usage of debit and credit cards. After the debit card system

was established over a decade ago, debit card usage rose sharply for a number of

years but growth has tapered off more recently. In contrast, credit card usage, which

grew only moderately in the first half of the 1990s, has accelerated as cardholders

have switched to credit cards for routine payments such as supermarket purchases

and utility bills, and “remote” payments such as theatre tickets and purchases over

the Internet. Many cardholders use their credit cards as a pure payment instrument:

preliminary data from the Reserve Bank’s new payments statistics collection suggest

that around 25 per cent of credit card balances do not incur interest because

cardholders have not made use of the revolving line of credit. This changing pattern

in how payments are made has coincided with the widespread introduction of

loyalty programs by credit card issuers, and has seen credit card usage reach annual

growth rates of around 26 per cent over the past three years. The number of credit

card payments per capita has risen to 42 a year, overtaking debit card payments

per capita of 36 a year (Figure 1.1).

(e) estimate

per year

1991 1993 1995 1997 1999 2001

No. No.

0

5

10

15

20

25

30

35

40

0

5

10

15

20

25

30

35

40

Debit

Credit

(e)

(e)

3

The debit card payment network in Australia had its origins in proprietary systems

set up by each of the major banks, and subsequently linked through bilateral

arrangements to enable cardholders to use their debit cards at any terminal. The

three major credit card schemes established in Australia were, however, collective

endeavours. Bankcard, a collaboration between Australian banks, was the first credit

card to be issued in Australia. Introduced in 1974, it was accepted nationally by

1977. MasterCard and Visa, the two international schemes in which Australian

financial institutions participate as members, followed in the 1980s. There are now

around 15 million credit cards on issue in Australia. Estimates of the market share

of the main credit and charge card schemes, in terms of cards on issue, are provided

by a survey of cards held by respondents (Table 1.2). Around 60 per cent of the

survey respondents who are over 18 have a credit card.

per cent of cards on issue, 2000/01

Visa 53.4

MasterCard 22.7

Bankcard 15.4

American Express charge card 3.6

American Express credit card 2.9

Diners Club 1.9

Source: Roy Morgan Research.

Bankcard, MasterCard and Visa are known as “four party” card schemes because

four parties are typically involved in the payment process. These parties are:

card for payment; and

The flow of fees (and interest payments) in a four party scheme is shown in

Figure 1.2.

4

This structure contrasts with that of American Express and Diners Club, which are

“three party” card schemes. In these proprietary schemes, American Express and

Diners Club generally act as sole issuers and acquirers, and the participation of

card schemes have traditionally issued charge cards, which provide the cardholder

with an interest-free period but no revolving line of credit; more recently, American

Express has also issued a credit card (the “Blue card”) which provides a revolving

line of credit similar to those of the four party schemes.

Payment instruments that involve the transfer of funds across the books of financial

institutions require co-operation between these institutions to ensure that payments

can be effected. Co-operation normally takes the form of various rules

and regulations agreed by participating institutions, either bilaterally or on an

industry-wide basis, covering such matters as procedures for funds transfers,

technical and operational procedures and criteria for participation.

The Bankcard, MasterCard and Visa credit card schemes have extensive rules and

regulations that govern their operations. The main characteristic of these schemes,

which distinguishes them from the three party schemes, is that the rules and

regulations are determined collectively by the financial institutions (issuers and

acquirers) that are members of each scheme, but that are otherwise competitors

1 The one exception in Australia is the American Express card issued by AMP Bank Limited.

Interchange fee

Merchant

service fee

Card fees

(and interest

payments)

Cardholder

Issuer Acquirer

Merchant

5

in providing credit card services to cardholders and merchants. In particular,

members of each card scheme collectively:

• set the wholesale fees (known as “interchange fees”) that are paid to the issuer

by the acquirer whenever a merchant accepts a credit card for payment;

• determine the criteria for membership of the schemes and the membership

fee (ie the price for access); and

• in the case of the MasterCard and Visa schemes, impose restrictions that prevent

merchants passing on the cost of accepting credit cards to cardholders – the

so-called “no surcharge” rule. (These restrictions are also imposed on merchants

by the three party card schemes.)

Although some minimum set of private-sector regulations is likely to be necessary

for the safe and orderly operation of a payment system, co-operative behaviour

between competitors which involves the collective setting of prices is rarely

where it is allowed, it typically requires some form of dispensation by competition

authorities on the basis that there are offsetting benefits to the public. In Australia,

it has the effect of substantially lessening competition, fixing or maintaining prices,

or restricting or limiting dealings with particular persons such as new entrants to

a market. However, such conduct may be authorised by the Australian Competition

and Consumer Commission (ACCC) if it judges it to result in a net public benefit.

Several payment systems in Australia have sought authorisation to ensure that their

regulations can satisfy a public interest test. For instance, the regulations and

procedures for four clearing streams operated by the Australian Payments Clearing

Association (APCA) – which govern the transfer of funds involved in ATM and

debit card (EFTPOS) transactions, cheques, bulk electronic and high-value

are thus free from the risk of prosecution for engaging in the behaviour authorised.

However, none of the credit card schemes in Australia are authorised under the

the Trade Practices Commission, the predecessor of the ACCC, on condition that

scheme members not impose restrictions on the freedom of merchants to determine

the prices they were prepared to charge customers paying either with cash or

Bankcard. The authorisation was revoked in 1990, one reason being the

Commission’s concerns about Bankcard’s restrictive membership criteria. Neither

6

Over the past couple of years, credit card schemes have come under closer public

policy scrutiny in Australia, and in some other industrial countries.

Some earlier official studies in Australia had raised questions about the structure

and efficiency of credit card interchange fee arrangements but, aside from

recommending further review, made no call for the regulations of the credit card

unanimously concluded that scheme restrictions on merchant pricing are

anti-competitive and that merchants accepting credit cards should be free to make

highlighted interchange fee arrangements and restrictions on access to credit card

schemes as areas of policy concern. The Inquiry recommended that a new Payments

System Board within the Reserve Bank should consider whether interchange fee

arrangements were appropriate for credit (and debit) cards; it noted that, if such

arrangements were priced contrary to efficiency principles, a review by the ACCC

would be warranted. The Inquiry was also concerned that the membership rules

of the two international credit card schemes might be used to restrict the ability

of non-deposit-taking institutions to compete in new payment technologies, and

recommended that the ACCC maintain a watching brief over these rules.

Since the Inquiry, two particular developments have sharpened the public policy

focus on credit card schemes in Australia. First, in response to the Inquiry, the

Payments System Board of the Reserve Bank and the ACCC undertook a detailed

study of debit and credit card schemes, drawing on information and data provided

by Bankcard, MasterCard and Visa and by a range of financial institutions that are

published in October 2000 as a basis for community discussion.

The Joint Study concluded that in card networks, competition is not working as it

should. In the case of the credit card schemes, the Joint Study found that:

• interchange fees are not reviewed regularly by scheme members on the basis

of any formal methodologies;

• interchange fees are higher than can be justified by costs, and scheme members

lack clear incentives to bring these fees into line with costs;

2 These studies are summarised in Reserve Bank of Australia and Australian Competition and

Consumer Commission (2000), pp 2-3.

7

• the “no surcharge” rule suppresses price signals that guide the efficient allocation

of resources; and

• restrictions by credit card schemes on which institutions can enter the acquiring

business were unjustified and restrictions on access to card issuing needed to

be reviewed.

When the incentives in an economy reflect demand and relative cost conditions,

consumers can make well-informed choices and it would be expected that lower

cost and more efficient payment instruments would thrive at the expense of the

more expensive or less efficient ones. The Joint Study concluded that this was not

the case in Australia. Instead, it concluded that Australia’s card payment arrangements

are encouraging consumers to use credit cards at the expense of other payment

instruments, particularly debit cards and direct debits, that consume fewer resources.

As a result, Australia has a higher cost retail payments system than necessary, and

much of this cost is borne by those consumers who do not use credit cards.

The second development, independent of the Joint Study, was a two-year

investigation of interchange fees in credit card schemes by the ACCC, in response

to a complaint by a merchant. The ACCC reached the conclusion that the collective

setting of these interchange fees was a breach of the price-fixing prohibitions of

members, in March 2000, that they should seek authorisation of the interchange

fee agreements if they could demonstrate that those agreements were in the public

interest; otherwise, the conduct had to cease.

From that point, the ACCC began discussions with a group of banks (the “review

banks”) about a possible application for authorisation. The banks initially proposed

to conduct a review of the arrangements for setting interchange fees but not of

restrictions on membership, notwithstanding the ACCC’s preliminary view that

these restrictions may significantly exacerbate the anti-competitive effect associated

with the collective setting of interchange fees. In September 2000, the ACCC

instituted legal proceedings against one major bank. Soon after, the banks agreed

to widen their review of credit card regulations to include membership issues.

The review was submitted to the ACCC in January 2001. After a series of further

discussions and a revised proposal, the ACCC concluded that the authorisation

process was unlikely to meet the competition and efficiency concerns raised in

the Joint Study, within an appropriate time-frame.

Accordingly, the Chairman of the ACCC wrote to the Governor of the Reserve Bank

in March 2001 recommending that the Payments System Board consider using

reform of the credit card schemes in Australia in the public interest. After

8

consultation with a range of interested parties, the Board took the decision to

bring credit card schemes in Australia under the Reserve Bank’s regulatory oversight.

In April 2001, the Reserve Bank formally “designated” the credit card systems

operated in Australia by Bankcard, MasterCard and Visa as payment systems subject

the ACCC discontinued its legal proceedings.

The Reserve Bank did not designate the three party card schemes in Australia,

American Express and Diners Club. These schemes do not have collectively

determined interchange fees, nor access rules which discriminate on the grounds

of institutional status. They do, however, impose restrictions on merchant pricing.

For this reason, the Reserve Bank confirmed that any decisions it took about

restrictions on merchant pricing in the public interest with respect to the designated

credit card systems would also apply to the three party card schemes.

Credit card schemes are also currently under official or judicial review in some

other industrial countries. In Europe, the European Commission has been

investigating Visa’s interchange fee arrangements for intra-regional operations and

its “no surcharge” rule. In the United Kingdom, the Office of Fair Trading has

been assessing an application by MasterCard/Europay for authorisation, under UK

competition laws, of its interchange fee arrangements for domestic transactions.

In the United States, following action by the Department of Justice, a US District

Court recently ruled in favour of MasterCard and Visa on their overlapping

ownership structure but against their “exclusionary” rules preventing their member

banks from issuing “rival” cards. In a separate and pending legal action, a group

of US merchants has sued MasterCard and Visa over their so-called “honour all

cards” rules, which require merchants to accept debit cards issued by the schemes

as a condition of accepting their credit cards.

The designation of the Bankcard, MasterCard and Visa credit card schemes is the

Payments System Board, which was established on 1 July 1998 as part of a major

reform of Australia’s financial regulatory structure. The mandate charges the Board

with responsibility for determining the Reserve Bank’s payments system policy

and it must exercise this responsibility in a way that will best contribute to:

• controlling risk in the financial system;

• promoting the efficiency of the payments system; and

• promoting competition in the market for payment services, consistent with

the overall stability of the financial system.

9

• designate a particular payment system as being subject to its regulation;

• determine rules on access to a designated system for new participants;

• set standards for safety and efficiency for that system;

• arbitrate on disputes in that system over matters relating to access, financial

safety, competitiveness and systemic risk, if the parties concerned wish; and

• gather information from a payment system, whether designated or not, or from

its participants.

in a designated payment system. The access regime must be one that the Reserve

Bank considers appropriate having regard to the public interest, the interests of

current participants in the system, the interests of people who may in the future

want access to the system, and any other matters the Reserve Bank considers relevant.

Access is defined as:

“… the entitlement or eligibility of a person to become a participant

in the system, as a user of the system, on a commercial basis on terms

that are fair and reasonable.” (Section 7)

An access regime deals specifically with the terms and conditions on which a

“person” (ie a constitutional corporation) can participate in a payment system,

and covers matters such as eligibility for participation, restrictions on the activities

new participants may undertake and the price of access (ie participation or

membership fees).

complied with by participants in a designated payment system, if it considers that

this is in the public interest. The legislation does not define or limit the matters on

which the Reserve Bank may determine standards. Standards deal with terms and

arrangements for entry might be.

Before imposing an access regime or determining a standard, the Reserve Bank is

required under Section 28 to consult widely. It has, in fact, given high priority to

the consultation process. It has received submissions from and met with (often

several times) a range of interested parties – including the designated credit card

schemes, the three party card schemes, financial institutions, retailers, billers and

consumer representatives – in the preparation of and in response to the Joint Study

and, specifically, to discuss designation of credit card schemes ahead of the Payments

System Board’s deliberations. Since designation, the Reserve Bank has received

additional submissions and has had a further series of meetings with interested

10

parties. The submissions have addressed the public policy concerns about efficiency

and competition in credit card schemes raised in the Joint Study and summarised

in the Reserve Bank’s media release on designation. Interested parties seeking further

guidance on submissions were provided with a detailed set of questions on the

operation of credit card schemes.

In total, 30 separate organisations have formally provided their views on the

operation of credit card schemes in Australia. A list of these parties is provided in

the Appendix. Submissions that these parties were prepared to put on the public

record are published in two companion volumes to this consultation document.

Throughout this process, the Reserve Bank has also continued to consult closely

with the ACCC.

The Reserve Bank may use its powers to impose an access regime or determine a

standard if it is in the public interest to do so. The public interest test is the critical

test for any intervention in the normal competitive processes of the market, whether

it be proposed action by regulatory authorities or potentially anti-competitive

own regulatory framework, in the form of rules and procedures agreed collectively

by the respective scheme members that are otherwise competitors in the provision

of credit card services. This regulatory framework is unique: in no other market in

on these prices and restrict entry to the market in a way that substantially lessens

competition. The regulatory framework of the credit card schemes benefits the

schemes and their members, as well as credit cardholders; however, the Joint Study

raised serious doubts about whether the community as a whole also benefits. For

this reason, the Reserve Bank’s starting point has been to assess whether the

regulations of the credit card schemes themselves can meet the public interest test.

interest. The Reserve Bank is to have regard to the desirability of payment systems:

“(a) being (in its opinion):

(i) financially safe for use by participants; and

(ii) efficient; and

(iii) competitive; and

11

(b) not (in its opinion) materially causing or contributing to increased

risk to the financial system.

The Reserve Bank may have regard to other matters that it considers

are relevant, but is not required to do so.”

In applying this public interest test, the Reserve Bank’s approach is consistent with

the broad objectives of competition policy in Australia. The blueprint for this policy

was set out in the report of the National Competition Policy Review (the Hilmer

Report) in 1993 and endorsed by Federal and State Governments at Council of

Australian Governments (COAG) meetings in 1994. Broadly speaking, competition

policy seeks to promote efficiency and enhance community welfare through the

encouragement of effective competition and the protection of the competitive

process. The Hilmer Report identified three dimensions of economic efficiency,

which are as relevant to markets for payment services as they are to other markets

highest valued uses (ie those that produce the greatest benefit relative to costs);

services at minimum costs; and

changes to technology and products in response to changes in consumer tastes

and in productive opportunities.

If it is to meet the broad objectives of competition policy, the payments system in

Australia needs to give maximum rein to the workings of the price mechanism

and the free movement of resources, provided the safety of the system is not

compromised. For this reason, the Reserve Bank sees the following competition

“benchmarks” as underpinning the public interest test in the payments system:

• relative prices charged by financial institutions to consumers who use payment

instruments should reflect the relative costs of providing these instruments as

well as demand conditions;

• merchants should be free to set prices for customers that promote the

competitiveness of their business;

• prices of payment instruments should be transparent;

• any restrictions on the entry of institutions to a payment system should be the

minimum necessary for the safe operation of that system; and

4 Independent Committee of Inquiry (1993), p 4.

12

• competition within the market for a payment instrument, and between different

payment instruments, should be open and effective.

If markets for payment services meet these benchmarks, the community can be

confident that the price mechanism will allocate resources efficiently to meet the

demand for different payment instruments, while the “contestability” of the markets

– that is, the threat of entry by new competitors – would ensure that payment

service providers earned no more than a competitive return on their investments

over time.

Even within a competitive environment, there is likely to be a role for private-sector

regulations to ensure the safe and orderly operation of a payment system. However,

if such regulations suppress or distort the normal market mechanisms, the onus

must be on those institutions imposing the regulations to demonstrate that

community welfare is not harmed.

This consultation document reviews the main regulations in the Bankcard,

MasterCard and Visa credit card schemes against the competition benchmarks

outlined above. It also sets out the Reserve Bank’s proposed reform of credit card

reviews the various justifications for interchange fees in credit card networks and

the processes by which these fees have been set by card scheme members in

Australia. The Chapter then provides a set of principles for interchange fee setting,

against which proposals by the credit card schemes and their members to improve

the efficiency and transparency of interchange fees are assessed. A draft standard

imposed by MasterCard and Visa and by the three party card schemes, are discussed

in Chapter 3. The potential impact of these restrictions on community welfare and

arguments for and against their abolition are analysed. A draft standard on merchant

requirements of the Bankcard scheme which have recently been liberalised. The

Chapter analyses the risks which credit card issuers and acquirers bring to card

schemes, and assesses how the schemes’ membership restrictions address these

risks. A draft access regime is provided.

Chapter 5 draws the analysis together by reviewing the main regulations of the

credit card schemes against the competition benchmarks that underpin the public

interest test. In the Reserve Bank’s opinion, there is a need for greater efficiency

13

and competition in Australia’s card payment arrangements. It is therefore proposing

to use its payments system powers to promote reform of credit card schemes in

Australia. The reform measures involve:

• an objective, transparent and cost-based methodology for determining

maximum interchange fees;

• freedom for merchants to recover from cardholders the cost of accepting credit

cards; and

• a more liberal access regime that allows for the entry of specialist credit card

service providers, both issuers and acquirers, to be supervised by the Australian

Prudential Regulation Authority (APRA).

The Chapter discusses the likely impact of these reform measures and analyses

some of the objections that have been raised to credit card reform. It also sets out

the next steps in the consultation process before the Reserve Bank’s proposed

standards and access regime are finalised.

Although Bankcard, MasterCard and Visa are well-established schemes, the economic

analysis of credit card networks is complex and relatively undeveloped. Much of

the recent theoretical literature has been sponsored by Visa itself. To help it evaluate

the arguments in the various submissions, the Reserve Bank commissioned a report

on the operations of credit card schemes from an international expert in network

economics – Professor Michael Katz, Arnold Professor of Business Administration,

Haas School of Business at the University of California. Professor Katz’s report,

document.

14

per cent of transaction value

(1974)

(1993) (1993)

(1993) (1993) (standard) (electronic)

Source: Bankcard, MasterCard and Visa.

5 Bankcard’s members agreed in 1996 to introduce an electronic rate of 0.8 per cent. This rate

is scheduled for implementation on 1 December 2001.

6 MasterCard and its Australian members have been unable to provide records of the rates

charged prior to 1993.

The Bankcard, MasterCard and Visa credit card schemes in Australia have wholesale

fees, known as “interchange fees”, that are paid to the issuer of the card by the

acquirer whenever a merchant accepts that credit card for payment. In each of the

schemes, the fees for domestic transactions (ie transactions between two Australian

members) are set collectively by their Australian members. Interchange fees are a

feature of four party credit card schemes in all countries.

Current credit card interchange fees for domestic transactions, the dates from which

they were applicable and the previous fees, where known, are shown in Table 2.1.

The international card schemes have a two-tier fee structure: an “electronic” rate

applies when a transaction is undertaken at an EFT terminal, the card is present

and the cardholder signs for the transaction, while a higher “standard” rate applies

for all other transactions. These two-tier fee structures are the same for both schemes.

15

Acquirers pass on interchange fees to their merchants through the merchant service

fee, which also includes a margin, almost always calculated as a percentage of the

value of the transaction, to cover the costs of providing acquiring services. Under

the “no surcharge” rule imposed by the international card schemes, which is

discussed in the next Chapter, merchants are not free to pass on the merchant

service fee to credit cardholders. Instead the fees, like other input costs, are passed

onto all customers through the prices of goods and services. Hence, although

acquirers but on the community as a whole through the general level of prices.

Interchange fees are a significant component of revenues from credit card issuing.

The Joint Study found that the average interchange fee received by issuers in 1999

was 0.95 per cent (and interchange fees currently generate revenues of around

$775 million a year to issuing banks). Revenue from this source accounted for

about one-third of total issuing revenues (Table 2.2). The other two-thirds of total

issuing revenues is generated by cardholders who make use of the revolving line

of credit (“revolvers”), that is, who do not pay off their accounts by the end of

the interest-free period. Preliminary data from the Reserve Bank’s new payments

system collection indicate that about three-quarters of credit card outstandings

are interest-bearing. Credit cardholders who use the credit card purely as a payment

instrument (“transactors”), that is, who pay off their balance by the end of the

interest-free period, make only a very small contribution to total issuing revenues,

mainly through annual fees.

per $100 transaction, 1999

a Interest payments plus 75 per cent of revenue from annual fees

and other sources.

b 25 per cent of revenue from annual fees and other sources.

c Interchange fee revenue.

16

The Joint Study found that interchange fees in Australia are not reviewed regularly

by credit card scheme members on the basis of any formal methodologies. It also

found that the fees are higher than the costs incurred by issuers in providing credit

card payment services to merchants and that – because of barriers to entry to the

schemes – competition does not seem to be bringing these fees into line with

costs. The Joint Study concluded that credit card interchange fee arrangements in

Australia are contributing to a structure of incentives that has encouraged the growth

of the credit card network at the expense of more economical payment instruments.

In its separate enforcement action, the ACCC reached the conclusion that the

arrangements for collective setting of interchange fees were in breach of the

controlling or maintaining another price (the merchant service fee).

This Chapter considers whether the arrangements for collective wholesale fee setting

in the designated credit card schemes are in the public interest. As background, it

introduces some basic concepts in the economics of networks. Next, it reviews the

justifications for interchange fees in credit card networks and the argument that

card scheme members, acting in their own self-interest, will set interchange fees

that maximise the community’s welfare. The Chapter then provides a set of principles

that, in the Reserve Bank’s opinion, need to be met if interchange fee arrangements

in credit card schemes are to be accepted as being in the public interest. Various

proposals by the card schemes and their members to improve interchange

fee-setting practices are assessed against these principles and are judged to fall

short in important respects. Accordingly, the Reserve Bank has decided to determine

a standard for the setting of credit card interchange fees in Australia to enhance

the efficiency and transparency of the price mechanism. The draft standard is

discussed in the concluding section.

The designated credit card schemes are examples of networks. A network is simply

a collection of participants that are connected to each other; well-known examples

of a network is that it involves a number of participants that all benefit from the

participation of others. In a four party credit card scheme, for example, the issuer

and the acquirer are both needed to produce the credit card transaction, and the

cardholder and the merchant jointly consume it. If any one participant is absent,

the transaction will not occur.

7 Payment networks are discussed in detail in Reserve Bank of Australia and Australian

Competition and Consumer Commission (2000), pp 23-31.

17

number of users of the system increases. Since individual merchants and cardholders

can benefit from an expanding network, credit card schemes generate network

effects for these users. An individual merchant can benefit from the take-up and

use of credit cards if it enjoys more sales and higher value sales, and if its customers

switch from payment instruments that are more costly to the merchant. An

individual consumer can benefit as more merchants accept cards because cards

can be used at more places, reducing the need to carry cash and increasing access

to purchases that can be made on credit. On this basis, a larger network is preferable

for participants to a smaller network. For equivalent services at equivalent prices,

consumers and merchants would be expected to prefer participation in a larger

credit card network than a smaller one. Product differentiation, however, means

that credit card networks of varying sizes can exist at the same time.

Beyond a critical mass, it is possible that network effects diminish as a network

gets larger. Katz, for example, notes that once a network has become established,

its viability may become less sensitive to small changes in its size, and hence it

similarly conclude that some network effects are exhausted at the margin. They

provide the example of the marginal benefits to other households of increasing

the number of households that own a particular type of video recorder, and argue

that they “are likely exhausted now that businesses that rent videotapes are about

Most submissions to the Reserve Bank have noted that the theoretical rationalisation

for interchange fees has its origins in an article by Baxter, written more than

ten years after interchange fees were introduced in four party credit card schemes

occur unless it provides a net benefit to each of the parties involved. In payment

systems involving the participation of four parties, this may require “side payments”

(such as interchange fees) between the merchant’s bank and the cardholder’s bank

if either of these banks is unable to recover its costs directly from its client. Provided

8 Katz (2001), p 14.

9 Leibowitz and Margolis (1994), p 140.

10 Baxter (1983). Baxter’s rationale was accepted by the US courts in the Nabanco case in 1983

as supporting the argument that interchange fees are not necessarily anti-competitive.

18

the “pooled” willingness of merchants and consumers to pay meets the total costs

of the system, the transaction can be facilitated with side payments structured to

ensure that there is a net benefit (or at least, no net cost) to all the participants in

the transaction.

Though providing a theoretical justification, Baxter’s analysis was silent on the

direction in which an interchange fee would flow. That would depend on the relative

willingness of cardholders and merchants to pay for credit card transactions, and

the relative costs of issuers and acquirers. If credit card issuing would not be

profitable at prices cardholders would be willing to pay, but credit card acquiring

would be profitable at prices merchants would be willing to pay, it may be possible

to make both activities profitable through an interchange fee paid by acquirers to

issuers. However, Baxter’s analysis does not establish that the interchange fee would

The role of the interchange fee as a balancing device is central to the arguments of

credit card schemes have not provided any empirical estimates of the demand curves

of merchants and cardholders for credit card services, or of the supply curves of

credit card issuers and acquirers, that would provide the basis for determining an

interchange fee consistent with the Baxter analysis.

Another justification for an interchange fee, which has appeared only recently,

class of network effects that arise when market prices do not fully capture the

consequences of the actions of one economic agent on another economic agent.

In these circumstances, economic agents may not take into account the effects of

their actions on others, resulting in a level of community welfare lower than it

analysis.

11 Katz (2001), p 25.

12 MasterCard, for example, argues that “the interchange fee is ... an efficient arrangement to

balance the costs and benefits of credit card transactions in the open system between issuers

and acquirers, and thereby the cardholders and merchants”. MasterCard International

(2001), p 38. See also Bankcard (2001b), p 1.

13 MasterCard International (2001), Visa International (2001a) and Australian Bankers’

Association (2001b).

14 See Leibowitz and Margolis (1994) and Varian (1984), p 259, for some definitions of

externalities.

19

Submissions to the Reserve Bank have argued that, in the absence of interchange

fees in a credit card scheme, the prices which card issuers would need to charge

cardholders to cover their costs would not reflect the net social benefits of

participation in the scheme. Potential cardholders facing these prices would not

take into account the benefits to others if they were to join and have no reason to

do so, even though it would be beneficial to all the scheme’s participants if they

did. Interchange fees paid by acquirers to issuers could ensure that these unrealised

benefits or externalities are captured (“internalised”) by allowing issuers to reduce

the prices they charge cardholders – that is, the interchange fees allow issuers to

“subsidise” cardholders. In this way, cardholders would face not the private cost

of using a credit card, but the social cost (that is, the cost to the issuer when the

card is used less the benefits both to cardholders and merchants when cardholders

join the scheme and use the card). The subsidy would therefore encourage

consumers to take up cards and use them, expanding the scheme to the benefit of

merchants and existing cardholders. Merchants would pay a price for credit card

services above the costs incurred by acquirers but would do so willingly, it is argued,

to ensure that they can enjoy the benefits of a larger credit card network.

The existence of network effects in credit card schemes is clear. However, whether

these effects are externalities, which would not be realised without the unusual

externalities would require that there are net social benefits to the growth of credit

card schemes that would not be captured in competitive market prices. Proponents

of the externalities argument focus on what they claim to be two main benefits

which credit card networks provide to merchants:

• lower transaction costs with credit cards; and

• increased sales.

A number of submissions have asserted that credit cards lead to lower transaction

no supporting evidence is provided for this assertion; the available evidence is to

the contrary.

instruments (taking into account both costs incurred and benefits provided),

15 Leibowitz and Margolis argue that “[w]hile network effects are common and important,

network externalities as market failures … are theoretically fragile and empirically

undocumented.” Leibowitz and Margolis (1994), p 135.

16 Australian Bankers’ Association (2001b), Australia and New Zealand Banking Group (2001c),

Westpac Banking Corporation (2000).

20

merchants would be expected to encourage the use of credit cards by offering a

discount to credit cardholders. What is observed, if anything, is the opposite – ie

discounts for cash – undermining the claims of substantial net benefits for

merchants at current merchant service fees.

There are no data on net benefits to merchants but the Australian Retailers

Association (ARA) has argued that credit cards are one of the most expensive

payment instruments for merchants to accept. It surveyed a number of its members,

representing a mix of retail spending and store size, about various payment

other staff processing time, collection, security and bank fees (including cash

deposit costs); charge cards issued by American Express and Diners Club are

The results of this survey are shown in Figure 2.1, which gives the absolute costs

of different payment instruments. A credit card transaction costs the merchants

0.00

0.50

1.00

1.50

2.00

0.00

0.50

1.00

1.50

2.00

Charge card Bank credit Debit card

card

Cheque Cash

$ $

Source: Australian Retailers Association.

17 Australian Retailers Association (2001b).

18 The data on charge cards also include the cost of store cards.

21

surveyed an average of $1.04 per transaction, over six times as much as a debit

card transaction. The lowest cost payment instrument is cash, at around $0.12 per

transaction. Charge cards cost about twice as much as credit cards. However, these

comparisons do not take into account the differences in the average value of

transactions undertaken with the different payment instruments, which are shown

in Table 2.3.

$

Cash 17

Cheque 35

Bank credit card 55

Debit card 57

Charge card* 69

* American Express, Diners Club and some store cards.

Source: Australian Retailers Association.

19 Debit card costs include any rebates that large retailers may receive, and hence understate the

processing costs to retailers of a debit card transaction. According to information from the

ARA, the processing cost of debit cards for the sample of merchants in Figures 2.1 and 2.2,

abstracting from any rebate, is around $0.20 or 0.4 per cent of the average transaction value.

For small merchants that might pay a merchant service fee of as much as $0.80 per debit

card transaction, the cost of accepting debit cards is higher than indicated in these figures.

The costs of accepting credit and charge cards are also typically higher for small merchants.

The costs of the different payment instruments, taking into account the average

value of transactions undertaken with each instrument, are shown in Figure 2.2.

On this measure, credit card transactions cost over twice as much as cash and still

the retailer less to accept than a credit card transaction.

The difference in the costs of the various payment instruments is most pronounced

when high-value purchases are considered. Merchant service fees for credit and

22

percentage of average transaction value

Source: Australian Retailers Association.

absolute terms with the value of the transaction. For debit cards and cash purchases,

on the other hand, merchants’ costs are largely unaffected by the size of the

transaction. On the basis of the ARA data, for example, the purchase of a $1 000

item would cost a merchant $29 if paid with a charge card and $19 with a credit

card. If paid by debit card, however, the transaction would cost up to $1 for a

small retailer and as little as $0.17 for a large retailer. The transaction would cost

only $0.12 if paid by cash.

The evidence for Australia is supported by data from studies of food stores in the

United States, undertaken by the Food Marketing Institute (FMI). Figure 2.3 shows

the cost of various payment instruments, as a proportion of average transaction

value, for the three FMI studies using data for 1994, 1997 and 1999. On this

evidence, a credit/charge card transaction in the United States costs around twice

as much as a cash or a debit card transaction.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Charge card Bank credit

card

Cash Debit card

% %

Cheque

23

A number of submissions have also asserted that merchants benefit from credit

cards because credit cardholders make “… more purchases, larger purchases and

It is essential that the assertion of network externalities associated with higher

merchant sales be stated correctly. Higher sales on credit cards for individual

merchants do not, of themselves, give rise to overall merchant benefits if:

• those sales would have taken place anyway using other payment instruments;

or

• the sales have merely diverted business from one merchant to another.

20 Visa International (2001a), p 21. See also Australian Bankers’ Association (2001b) and

(2001c), Australia and New Zealand Banking Group (2001c) and American Express (2001).

percentage of average transaction value

* The FMI studies do not provide a breakdown between credit and charge cards.

Source: Food Marketing Institute (1994, 1998 and 2000).

0.0

0.5

1.0

1.5

2.0

0.0

0.5

1.0

1.5

2.0

1994

1997

1999

Credit/Charge card* Cheque Debit card Cash

% %

24

If a customer who would otherwise have used a debit card when visiting their

normal merchant undertakes a transaction on a credit card to gain loyalty points,

the merchant gains no additional sales, but incurs higher transaction costs. If the

customer switches to a different merchant because it accepts credit cards while

rivals do not, that merchant will gain additional sales but merchants as a group

will not. The network externalities argument requires that credit card usage leads

to an individual merchant also applies to merchants as a whole would be a simple

but fundamental “fallacy of composition”.

None of the submissions asserting network externalities has provided any evidence

of a permanent economy-wide increase in sales from credit card usage. The

Australian Bankers’ Association (ABA), for example, has stated that studies of the

Visa has asserted that credit cards lead to new and higher merchant sales, although

the new uses it cites – grocery, utility, telephone and Internet payments – may

simply represent substitution from other payment instruments or different sales

distribution channels. Consumers, for example, are unlikely to purchase more

groceries or use more electricity because they are paying by credit card. Visa has

also claimed that data on the average value of a credit card transaction show that

to the Reserve Bank by the ARA, and separately by some major retailers. As shown

in Table 2.3 above, the average value of a credit card transaction is much higher

21 “The impact of accepting credit cards on a merchant’s revenue and profits was studied and

validated in the 1970’s and 1980’s; those studies no longer exist. Current efforts have been

focussed on assessing the merchant benefits of accepting credit cards for new and evolving

markets – hypermarkets; utilities; government payments. This work is not in the public

domain.” Australian Bankers’ Association (2001c), p 8.

22 Visa International (2001b), p 28. Elsewhere, Visa has claimed that credit card use under a no

surcharge rule leads to an increase in merchant sales and, because of economies of scale, to

lower retail prices for the benefit of all consumers, not just credit cardholders. Visa

International (2001a). Katz has dismissed this assertion as “… a seriously flawed argument

which fails to recognize that, to the extent card use merely diverts sales among merchants, it

has no effect on aggregate sales and the realization of economies of scale.” Katz (2001),

pp 41-42.

23 These data differ from the average transaction values derived from the Reserve Bank’s

Transaction Cards Statistics Collection, which give the average value of a credit card

transaction at around $110 and that of a debit card around $60. The difference is most likely

due to sampling. The ARA survey covered a group of retailers for which big ticket credit card

sales are a relatively small share of sales. The Reserve Bank’s data averages all credit card

transactions, including big ticket purchases such as home furnishings and travel, that cannot

be made on debit cards because of transaction limits imposed by issuers. The data also

include cards used for business purposes which have a higher average transaction value.

25

24 There is some evidence for this. See Reserve Bank of Australia and Australian Competition and

Consumer Commission (2000), p 16.

25 Visa International (2001a), Australian Bankers’ Association (2001b) and (2001c), Westpac

Banking Corporation (2000).

26 Katz (2001), p 11.

The difference in average transaction values may reflect a number of factors. First,

it is consistent with the fact that consumers use different payment instruments for

different types of purchases; small items such as milk and bread will tend to be

purchased with cash while more expensive items, such as white goods, tend to be

purchased using a credit card or other non-cash instrument. Using a credit card

rather than cash is unlikely to result in more milk and bread being consumed.

the higher average expenditure on credit cards may simply reflect the higher income

of their users, who would be expected to spend more no matter what payment

instrument they use.

The argument that credit card usage leads to higher merchant sales is, equivalently,

an argument that credit card usage leads to higher consumption. Proponents of

the externalities case have claimed that credit cards, by offering cardholders a “buy

Again, however, it is essential that the network externalities argument be correctly

purchase an item now must pay interest and repay the principal in the future; in

so doing, the consumer’s future disposable income and consumption expenditure

will be reduced.

There is a considerable body of economic literature on the determinants of aggregate

consumption. This literature acknowledges that the availability of credit may alter

consumption patterns by enabling consumers to smooth their consumption

expenditure over time; this in itself can be of benefit to the economy but it is a

characteristic of credit generally, not just credit cards. Fundamentally, however,

consumption is determined by expected income and “wealth”, which is determined

by the economy’s productive capacity. Consumption now at the expense of savings

reduces the level of wealth and future income flowing from that wealth; this, in

turn, constrains consumption in the future. The notion of “mortgaging the future”

is a real world recognition of this point. The economic literature is summarised by

Katz, who concludes that the claim that credit card use leads to a permanent and

26

None of the submissions has provided any evidence supporting the assertion of

network externalities in consumption. The ABA cites three academic references

but these do not demonstrate that the provision of credit leads to a permanent

increase in consumption. In a research report commissioned by Visa for another

purpose, KPMG offers the observation that “[t]he period over which credit card

debt has expanded most significantly in Australia (ie the last ten years) has also

been a period of sustained growth in household consumption and Gross Domestic

been on a strong upward trend; it says nothing about causality. Elsewhere, however,

the KPMG report concluded that credit card debt could have an impact on the

economy’s savings only if used as a source of long-term finance and that this impact

A comprehensive study of the impact of credit cards on consumption was

undertaken by the Board of Governors of the US Federal Reserve System in 1983,

as input to Congressional consideration of a law that encouraged price discounts

larger than would otherwise be the case, or primarily affect the timing or

composition of consumer spending. Though the study itself is dated, the issues

remain relevant. It noted that “if card use has no appreciable impact on total

spending, then retailers as a group would realize no net sales gain to offset the

industry-wide costs of honoring credit cards. Of course, merchants who do honor

credit cards might gain sales from those who do not accept them, but that situation

becomes less likely as credit cards reach a mature stage of development and retailer

microeconomic evidence, in the form of a household survey of unplanned

purchases, and macroeconomic evidence on the relationship between credit card

use and savings rates. It concluded that “[o]n the whole, the household survey…

as well as existing macroeconomic research provide little grounds for believing

that credit cards generate incremental sales in sufficient volumes to offset credit

In the Reserve Bank’s opinion, arguments that credit card schemes generate network

externalities are unconvincing. In the first place, although credit cards clearly provide

benefits to individual cardholders and merchants, the benefits to cardholders and

27 KPMG Consulting (2001), p 40.

29 Board of Governors of the Federal Reserve System (1983).

27

merchants as a whole are overstated. No evidence has been provided that credit

card usage reduces transaction costs for merchants as a whole. Nor has evidence

been provided that credit card usage leads to a permanent increase in sales for

merchants as a whole, or, equivalently, a permanent increase in aggregate

consumption. The evidence that is available contradicts this assertion. The claim

that credit cards allow consumers to spend more than they would otherwise has

merit, but only at the level of the individual consumer and only over the short

run. And, of course, that claim loses force to the extent that credit cardholders do

not make use of the revolving credit facility but settle their account in full each

Secondly, even if there are potential network externalities in credit card schemes,

an interchange fee may not be the only way to internalise them. For some of these

effects, the price mechanism itself may achieve the same outcome, through

differential pricing by merchants. If merchants did indeed benefit from credit card

use through lower transaction costs, they would encourage customers to use credit

cards rather than other payment instruments by offering a price discount to credit

cardholders. In responding to the differential prices, consumers would take into

account not just their own costs and benefits but also those of merchants; the

price mechanism would ensure that the benefits received by merchants were passed

transaction costs from credit card use (after allowing for any merchant benefits),

they would have an incentive to reduce credit card use relative to other payment

instruments through charging a higher price to credit cardholders; consumers

would again confront the social costs of using different payment instruments.

Differential pricing may therefore allow the market to internalise effects that would

Chapter.

Thirdly, it is necessary to consider how any externalities would be affected as a

network increases in size. Visa has argued that:

“there is nothing in the theory of interchange that suggests that just

because a market is mature it will no longer be subject to network

32 The KPMG report estimates that 68 per cent of credit card users pay off their credit card debt

in full at least once a year. It also notes that the turnover rate of debt has increased since the

mid 1990s, indicating that “[c]redit card debt is becoming shorter in nature.” KPMG

Consulting (2001), p 19.

33 Frankel (1998), Gans and King (2001a) and Katz (2001) all recognise this as an alternative

way of “internalising” externalities.

34 Katz (2001), p 21.

28

externalities. Adding a cardholder to the network provides benefits

to merchants, whether it is the first cardholder or the last cardholder

to join the system. Similarly, when an additional merchant decides to

accept credit cards this provides additional benefits to cardholders,

even if there are already a large proportion of merchants in the

Economic analysis casts doubt on whether these effects are significant. For example,

two earlier articles sponsored by Visa concluded that network externalities can

decline to zero as a network expands. Chang, Evans and Schmalensee note that “…

just as economies of scale do not generally persist at all levels of output, in many

networks the importance of network externalities falls with network size. At some

point, we would expect that additional network efficiencies from new members

would fall to zero. It is hard to imagine that the Visa and MasterCard systems would

gain anything at all from having one more New York bank join their systems, for

instance, even though the addition of the first such bank might well have had

adding that “[t]he natural limits on network externalities together with product

differentiation explain why multiple networks can survive in the same industry.

Katz has noted that “[i]t is possible that, at a sufficiently high level of membership

on either the merchant side or the cardholder side, marginal changes in membership

generate smaller or no benefits to other parties. For instance, to the extent that the

incremental merchants on a network are substitutes for merchants already on the

network, the value to a cardholder from having additional merchants accept cards

Finally, the pricing behaviour of credit card schemes does not appear consistent

with their stated objective of maximising benefits to cardholders and merchants

by maximising network size. In Australia, credit cardholders face a positive price

even though the marginal cost of a credit card transaction is positive. A pricing

strategy that would encourage credit card holding as well as use would be similar

to that used by mobile phone companies. It would involve credit card schemes

35 Visa International (2001a), p 15. See also Australian Bankers’ Association (2001b) and

Frontier Economics (2001).

36 Chang, Evans and Schmalensee (1998), p 314.

37 Evans and Schmalensee (1999), p 153.

38 Katz (2001), p 14.

29

heavily subsidising consumers to join, just as mobile phone companies have

subsidised the sale of handsets; by lowering the fixed cost of joining, credit card

schemes could expand their membership and raise revenue by charging transaction

fees on the basis of usage. Under this pricing structure, cardholders who use the

system most would contribute most to the cost of running it.

The pricing structure of the credit card schemes is the reverse of this. Katz notes

that:

“… economic analysis indicates that, when there are significant

network effects, charging below-cost annual fees is a more effective

means of encouraging cardholding than is paying rebates or charging

below-cost transactions fees. This finding suggests that either the

associations and their members have been unable to implement

strategies to pursue their objective of encouraging membership, or

below-cost pricing is driven by considerations other than internalizing

The previous section analysed the theoretical justifications for interchange fees in

credit card schemes. From the public interest viewpoint, a related and equally

important issue is whether profit-maximising credit card scheme members, acting

collectively, will have an incentive to set an interchange fee at approximately the

level that maximises economic welfare (ie is “socially optimal”).

In standard economic models of markets with perfect competition, the pursuit of

profit maximisation by individual firms generates a set of market prices that enable

consumers to make efficient decisions; in this way, economic welfare is maximised.

In recent years, formal economic models have been developed to assess the

conditions under which the collective setting of interchange fees, by credit card

scheme members pursuing their own self-interest, will produce outcomes that

also maximise economic welfare. This work, which has been sponsored by Visa, is

models are cited as providing a theoretical underpinning for claims that credit

card interchange fees are as close to optimal as could be expected.

Schmalensee’s model shows that an interchange fee determined by scheme

members will not only maximise usage of the credit card system (and system

39 Katz (2001), pp 48-49.

40 See Schmalensee (2001) and Rochet and Tirole (2000).

30

profits) but also economic welfare. Schmalensee compares the interchange fee that

maximises total issuer and acquirer profits with the fee that would maximise a

measure of economic welfare. Under certain specific conditions – a monopoly

issuer, a monopoly acquirer and linear demand functions for consumers and

merchants – profit maximisation is shown to maximise card use and Schmalensee’s

measure of economic welfare.

In reviewing Schmalensee’s model, Katz has drawn attention to the measure of

economic welfare on which his results are based. Schmalensee adopts the

assumption that merchant willingness to accept cards can be taken as a measure of

the social benefits of credit cards. But, as has already been established, this may be

a very misleading measure of economic welfare because summing up individual

merchants’ willingness to accept credit cards, without accounting for the impact

on rival merchants, overestimates the benefits of card use to merchants as a group.

Katz shows that the mismeasurement of welfare in Schmalensee’s model overstates

the benefits of card use by 100 per cent and therefore errs toward supporting

interchange fees that encourage excessive card use. Katz’s conclusion on the

Schmalensee model is that it “… does not provide a rigorous basis for concluding

In the Rochet and Tirole model, the optimal interchange fee is zero if issuing and

acquiring are perfectly competitive. However, when issuers are less than perfectly

competitive, the model shows that an interchange fee can promote efficiency. It

does this not by internalising network externalities but by inducing issuers to reduce

their fee to cardholders and encourage the take-up of credit cards, thereby

compensating for the natural tendency of issuers with market power to restrict

output (ie the number of credit cards). With market power, issuers’ profits rise

with the interchange fee and issuers have an incentive to push the fee up as high

as possible without forcing merchants out of the system. The relationship between

the fee determined by an issuer-controlled credit card scheme and the socially

optimal fee in this model therefore depends on the degree of merchant “resistance”

to card acceptance. Where merchants have a strong degree of resistance, both the

privately and socially optimal interchange fees are equal to the highest level

consistent with merchant acceptance of cards.

Rochet and Tirole also find, however, that if merchants have limited resistance to

accepting cards, issuers will push the interchange fee above the socially optimal

level, allowing them to reduce cardholder fees below the optimal level and resulting

in the overprovision of credit card services: “a low merchant resistance is the worst

41 Katz (2001), p 27.

31

Rochet and Tirole note that merchants may accept credit cards even though the

merchant service fee exceeds the technological and payment guarantee benefits

they derive from card acceptance because “[p]ayment card systems can exploit

They also note that the use of cash rebates and other inducements also weaken

merchant resistance, increasing the ability of issuer-controlled schemes to set

interchange fees higher than is socially optimal.

An alternative approach to analysing the impact of interchange fees on economic

the size of the credit card system and no harmful effects on cash customers, no

matter at what rate it is set; ie the interchange fee is “neutral”. If the interchange

fee were to change, merchant service fees and rebates to credit cardholders would

both change by the same amount and in the same direction. This could happen if

merchants are able to recover the costs of different payment instruments from

their customers; it could also happen even if merchants are not able to do so.

According to this view, if credit card transactions are more costly for merchants

than cash transactions, some merchants will specialise in cash sales and will be

able to undercut merchants selling to both cash and credit card customers. Cash

customers will therefore not shop at stores that also serve credit card customers.

The market will ultimately segment into two groups: those stores selling at lower

prices to cash customers only, and those stores selling only to credit card customers

at higher prices incorporating merchants’ costs of accepting credit cards. It should

be noted, however, that credit card schemes and their members do not accept this

neutrality argument; on the contrary, they argue that any interchange fee lower

Whatever its theoretical support, the neutrality argument would seem to have little

practical weight. Though there can be a significant difference in costs to merchants

between accepting cash and credit card transactions, that difference in most cases

would not be enough to make it attractive for merchants to set up as cash-only

42 Rochet and Tirole (2000), p 18.

44 The notion that interchange fees might be neutral under certain conditions was discussed by

Carlton and Frankel (1995) and Frankel (1998) and more recently by Gans and King

(2001a).

45 Visa International (2001a) and MasterCard International (2001). MasterCard characterises

the “self reinforcing cycle” set in train by lowering the interchange fee as a “death spiral”,

p 11.

32

merchants simply to avoid merchant service fees on credit cards. Submissions can

give only one example of a cash-only merchant in a sector that now usually accepts

credit cards – the supermarket chain, Aldi. However, Aldi’s low prices are the result

of its general “no frills” approach to grocery retailing, of which its unwillingness

ready availability of cash discounts for items such as white goods demonstrates

that there may well be an incentive for a merchant to adjust prices where the

resulting dollar difference is sufficiently large. Drawing on the ARA survey quoted

earlier, the average cost to a merchant of accepting a credit card for payment on a

$1 000 refrigerator, for example, would be $19 but the same cost on a $200 basket

of groceries would be $4 and on a tank full of petrol not much more than $1. It is

quite unrealistic to expect that retailers will set up separate stores to compete on

one aspect of their business – the payment method – when other means by which

they differentiate themselves are at least as, and usually more, important.

In summing up, the economic literature on credit card networks is undeveloped

the assumptions made and, by focusing only on the choice between cash and credit

cards, the models do not deal with the more general situation of competition

between different payment networks. In the Reserve Bank’s opinion, the economic

literature gives grounds for concluding that the collective setting of interchange

fees has the potential to generate a fee structure that promotes overuse of credit

cards. After reviewing recent contributions, Katz states that:

“The findings on the relationship between the interchange rate chosen

by a rationally self-interested association and the socially optimal

interchange fee can be summarized as follows. In general, they can

be expected to differ from one another. One source of the divergence

is that private parties will respond to merchants’ willingness to accept

cards, which may be a poor measure of the overall effects of card

acceptance on merchant welfare. Because of this distortion in

acceptance incentives, privately optimal interchange fees may promote

46 For example, Aldi only stocks its own brands which it sources in bulk from its own suppliers;

it only stocks 600 items rather than 20 000 or more in a typical supermarket. It also charges

for shopping trolleys and bags, and reduces handling costs by selling goods from cartons

rather than unpacking onto shelves.

47 “The payment card industry has received scant theoretical attention, and it won’t come as a

surprise to the reader that more research is warranted.” Rochet and Tirole (2000), p 34.

48 Katz (2001), p 29.

33

Notwithstanding the lack of strong theoretical support, MasterCard and Visa have

claimed that the processes by which interchange fees are set in Australia produce

efficient outcomes for the schemes and the community generally.

Visa has argued that, under competitive pressures, the interchange fee is set at or

close to the optimal level by scheme members using their commercial judgment.

Visa claims that this judgment “… is then tested in the negotiating process over

interchange between members, which elicits information about the likely outcomes

competitive process by which interchange fees have been determined is as follows.

The division of revenues from cardholders and merchants is determined by the

interaction of (i) the relative price elasticity of demand of cardholders and

merchants (ii) the positive externality arising from cardholder membership and

Despite these descriptions of a competitive negotiating process for determining

interchange fees, the actual interchange fee structure in Australia has been highly

rigid. Australian members of MasterCard have not changed interchange fees for

domestic transactions since 1993; no records have been made available on

interchange fees for domestic transactions in 1993, when they set domestic fees

to over-ride those set by the relevant Asia/Pacific boards/executive committees,

but have left the fees unchanged since then. Australian members of the MasterCard

and Visa schemes reviewed domestic interchange fees in the mid 1990s using the

Nonetheless, none of the Australian members of either scheme could provide any

information to the Reserve Bank on how the current level of interchange fees had

been determined. Bankcard has not changed its interchange fee since the scheme

was established in 1974. Bankcard and its members were unable to offer any

justification for the original fee – they claimed to have “no records that deal with

that fee.

49 Visa International (2001a), p 25.

50 Australian Bankers’ Association (2001d), p 10.

51 As noted above, MasterCard and its members have claimed to have no record of the

interchange fee charged prior to 1993.

52 MasterCard and Visa supplied this work to the Reserve Bank during preparation of the

Joint Study.

53 Bankcard (1999).

34

In short, as the Joint Study found, there is no evidence that credit card interchange

fees in Australia have been regularly reviewed by scheme members. In contrast to

the practices of the international schemes in other countries, no formal

methodologies for determining these fees have been applied.

This rigidity in interchange fee setting in Australia has had a number of

consequences:

• Australia has not enjoyed reductions in interchange fees as the credit card

networks have grown in scale and per unit costs declined, as happened in the

• interchange fees were not lowered when annual fees to cardholders were

introduced from 1993, and cardholders began to bear more of the card scheme

costs directly. Visa members actually increased interchange fees at that time;

and

• Australia does not have the range of interchange fees for different types of

merchants or transactions that other countries have. In the United States, for

example, there is a range of different interchange fees including fees for

electronic, paper and “card not present” transactions (for example, Internet)

None of the Australian members of the designated credit card schemes has sought

– which are normally secret – differ in some cases from those quoted by other

sources and, in one case (the United Kingdom), give numbers that the international

card schemes were not prepared to have published in the recent official review of

hand, has claimed that a number of other countries in Europe have interchange

54 Evans and Schmalensee note that both interchange fees and merchant discounts declined in

the 1980s in the United States, citing this as evidence that Visa’s interchange fee did not have

anti-competitive consequences. Evans and Schmalensee (1995), p 892. Since then, the

pressures on interchange fees in the United States have been upwards as the schemes, with

their large merchant bases, compete for issuers. See Balto (2000).

55 See www.chase.com for some US interchange fees and a brief description of the reasons for

differential fees. Chakravorti and Shah (2001) report a large number of different interchange

fees for MasterCard and Visa in the United States. Also see Evans and Schmalensee (1999),

p 132.

56 Australian Bankers’ Association (2001b), p 39.

57 See Cruickshank (2000).

58 Australian Retailers Association (2001b), p 17.

35

Reserve Bank asked both MasterCard and Visa if they would verify the data on

interchange fees in other countries, but neither scheme has responded to this

request. In any event, interchange fees in Europe can be expected to fall over time

as a result of intervention by competition authorities, which is discussed below.

Visa, for example, has proposed a reduction in its weighted average interchange

fees for intra-regional European transactions to a maximum of 0.7 per cent over a

five-year period.

On the other hand, the international card schemes have argued that strong

competition ensures that current arrangements for the collective setting of

that competition between credit card schemes and between credit cards and other

payment instruments ensures that interchange fees in their schemes cannot go

too high or too low. If the interchange fee (and hence the merchant service fee) is

too high, merchants will stop accepting credit cards in favour of cheaper payment

instruments. If the interchange fee is too low, issuers will be unwilling to issue

the healthy growth of the open systems, the absence of market fragmentation, and

the proliferation of interchanged transactions in Australia, the interchange fees of

Since the claim of strong competition between different brands and types of

payment instruments in Australia is critical to judgments about whether collective

interchange fee setting is in the public interest, this claim needs to be explored in

some detail.

The analysis of interchange fees and their impact on economic welfare suggests

that a collectively set interchange fee is more likely to be consistent with maximising

economic welfare under conditions of:

• strong competition between the credit card schemes;

• strong competition between credit cards and other payment instruments; and

• a balance of issuing and acquiring interests in the fee-setting process.

59 Visa International (2001a) and MasterCard International (2001). Wright (2000), based on

Rochet and Tirole (2000), also makes some claims about the optimality of Visa’s collective

fee setting on p 117 of Visa (2001a).

60 MasterCard argues that the low merchant acceptance of credit cards in Korea and Japan,

where interchange fees are around 3 per cent and up to 5 per cent, respectively, is evidence

of the competitive effect. MasterCard International (2001), pp 6-9.

61 MasterCard International (2001), p 9.

36

Although the card schemes assert otherwise, there appears very limited competition

between the designated credit card schemes in Australia. A major factor is scheme

governance. Overlapping governance means that the same banks control all three

schemes in Australia; in particular, the four major banks are on the governing boards

and executive committees of all three schemes (Table 2.4). Given these

arrangements, there appears little incentive for members to promote one scheme

over another:

• members typically issue all three brands and some of the major banks and other

members provide customers with a single application form for all three card

Source: Bankcard, MasterCard and Visa.

37

three schemes with almost identical payment services and fees;

• acquirers do not promote any particular card scheme to merchants but offer to

acquire transactions from all three schemes, generally for the same fee for each

scheme; and

• in loyalty programs offered by some of the major banks, loyalty points accrue

to a customer irrespective of the credit card used. As discussed later, loyalty

programs of this type are designed to promote allegiance to the card issuer,

In brief, competition between the credit card schemes appears limited to advertising

that is funded by the schemes themselves to promote the brand to cardholders.

Competition between payment instruments is critical to the claim that interchange

fees cannot rise above “efficient” levels because such competition will keep them

in check. If a particular scheme dominates credit card payments or has a sufficiently

strong card base, merchants would find it difficult to opt out of that scheme and

scheme members would be able to set the interchange fee above the efficient level.

Though supportive of the collective setting of interchange fees, Baxter himself

concluded that “antitrust and banking authorities should be alert to ensure that

the number of payment systems is as large as the attainment of scale economies

permits. Though unbridled autonomy within a system cannot be attained, unbridled

In Australia, the designated credit card schemes appear to have a dominant market

position. Visa alone accounts for around 53 per cent of all credit and charge cards

on issue in Australia. If MasterCard and Bankcard are included, cards issued by

members of the three designated credit card schemes account for around

62 “Net issuer” rules in the credit card schemes, discussed in Chapter 4, encourage members to

issue all three cards. An acquiring institution needs to be able to acquire all brands in order to

attract merchants but, to avoid financial penalties imposed by the schemes, also needs to

issue some volume of cards. Hence, any member that wants to acquire will typically issue all

three brands.

63 For example, the Commonwealth Bank’s True Awards program is the same for cards issued in

all three card schemes and National Australia Bank’s Gold Rewards program is the same for

cards issued by both Visa and MasterCard.

64 Baxter (1983), p 587.

65 Roy Morgan Research, quoted in Table 1.2 above.

38

Club have a higher share of transaction values than of cards on issue, although

preliminary data collected by the Reserve Bank suggest that the three designated

credit card schemes still account for around 85 per cent of the value of credit and

Nonetheless, the designated credit card schemes claim that the three party schemes,

American Express and Diners Club, remain their closest competitors. However,

according to the ARA, merchant service fees for the three party schemes are around

100 basis points above those charged by the designated credit card schemes. The

three party schemes also have much smaller cardholder and merchant bases, raising

the question about the degree of competitive pressure that these schemes can apply.

Visa itself has claimed that “… the fact that there are more VISA cardholders makes

accepting VISA cards more attractive to merchants than accepting AMEX cards, even

between the three and four party card schemes is discussed more fully in Chapter 5.

Debit cards are also a potentially strong competitor for credit cards. From the

viewpoint of the merchant, a debit card also provides a guaranteed, pre-authorised

payment; for cardholders who do not face a cash constraint, a debit card is a close

number of transactions than credit cards. However, debit cards are not actively

promoted – through loyalty programs, other forms of inducements or advertising

– by financial institutions that are also members of the designated credit card

by the four major banks, discourages consumers from using these cards in

preference to credit cards. Debit cardholders face a per transaction fee for using

their debit card (beyond a fee-free threshold) while credit cardholders do not face

a per transaction fee and earn a rebate (ie a negative cost) if they participate in a

credit card loyalty program. Competition between payment instruments has also

been undermined by the limited promotion in Australia of the debit cards of the

66 The ACCC has ruled that, in its competitive analysis of the Commonwealth/Colonial merger,

credit cards are a relevant market distinct from other personal lending on the credit side and

from transaction accounts on the payments side. See Goddard and Walker (2001).

67 Visa International (2001a), p 3.

68 Proprietary debit cards do not provide a refund for goods and services paid for but not

delivered. The right to a refund can be important for purchases where goods and services are

normally delivered after payment, but is largely irrelevant for purchases such as in service

stations, supermarkets or restaurants.

69 The exception appears to be the Commonwealth Bank’s “Ezy banking” debit card, which

provides loyalty points if the card is used for transactions at Woolworths’ stores.

39

international card schemes which, unlike proprietary debit cards, have world-wide

The preference of card issuers to promote the use of credit cards over debit cards

is not difficult to understand. At the simplest level, card issuers receive interchange

fees each time a credit cardholder makes a purchase (averaging around $0.95 for

a $100 transaction) but they pay interchange fees (averaging around $0.20-$0.25

a transaction) whenever a debit card is used. Credit cardholders who do not pay

off their accounts in full each month also generate interest revenue to issuers. The

Joint Study showed that issuers incur higher costs in providing credit card services

compared with debit cards (largely because of the costs of the interest-free period,

credit losses and fraud), but nonetheless earn more net revenue when their

customers use credit cards rather than debit cards.

In the face of well-established credit card schemes with wide customer popularity,

merchants claim they have little option but to accept credit cards; once they do,

however, they are locked in. The Reserve Bank is not aware of any evidence, in

Australia or elsewhere, of merchants quitting credit card schemes on any significant

scale after they had signed up. Shell has stated that “[i]n the case of Shell (as in the

case of most other retailers) the non-acceptance of credit cards is simply not an

option. Card acceptance is necessary simply to gain entry to consumer

the potential to set interchange fees above the socially optimal level and promote

inefficiently high levels of credit card usage, with little risk of losing merchant

acceptance. This danger has already been illustrated by experience in the United

fees, both in the credit card market and in the off-line debit card market (which

The interests of merchants and cardholders both need to be taken into account in

assessing the effects on economic efficiency of the negotiating process on

interchange fees which the international card schemes have described. If issuing

70 The Joint Study expressed concerns about the interchange fees applying to Visa debit cards,

which the Reserve Bank has taken up with Visa and domestic issuers, but not about the

product itself.

71 Shell (2001), p 13. The Restaurant and Catering Association of Australia noted that the

business of its members “… relies on credit card transactions for the majority of its

settlement activity”, Restaurant and Catering Association of Australia (2001), p 2.

72 Balto (2000).

40

is more strongly represented in this process than acquiring, there is likely to be

insufficient account taken of merchants’ interests; the opposite would apply if

acquiring is more strongly represented.

The fact that, in Australia, the large issuers are also large acquirers might suggest

that the voice of acquirers will be strong. The ARA has argued, however, that the

interchange fee “… is not subject to independent assessment and negotiation from

there is every indication that the issuing side of the business takes precedence.

Submissions from card schemes and their members have consistently put the issuers’

viewpoint – that any lowering of interchange fees will have a deleterious impact

on issuers and cardholders. The Reserve Bank has not received a single submission

from credit card scheme members that emphasised the positive impact of lower

interchange fees on acquirers’ and merchants’ business. The obligation on merchants

under the “no surcharge” rule to pass on higher merchant service fees in prices

charged to all customers also weakens the balancing forces needed for efficient

interchange fee setting. The Joint Study reached the conclusion that: “… card scheme

members are under little pressure to lower interchange fees – as issuers they receive

revenue from these fees and as acquirers they can pass the fees on to merchants.

Merchants, in turn, have little scope to resist since they do not have the option of

shopping around for an acquirer seeking to recover a lower interchange fee; their

More generally, there is no evidence of any competitive negotiations on interchange

fees in any of the three designated credit card schemes, and the processes that do

occur lack transparency. Interchange fees have been rigid and, since 1993, have

been the same for all three schemes for transactions incurring the “standard” rate.

Despite the Reserve Bank’s request, none of the three designated credit card schemes

or their members was able to produce any evidence that this rigidity in fees is the

result of ongoing negotiation, taking into account changing market and cost

conditions.

To sum up, the competitive conditions necessary to ensure that the collective setting

of interchange fees is in the public interest are not present in Australia. Competition

between the three designated credit card schemes, and between credit cards and

other payment instruments, lacks vigour in the face of overlapping governance

arrangements and the dominant position of the four major banks, which are the

73 Australian Retailers Association (2001b), p 7.

74 Reserve Bank of Australia and Australian Competition and Consumer Commission (2000),

p 58.

41

main suppliers of credit card services and most other payment instruments in

Australia. These banks have clearly preferred to promote credit cards at the expense

of other payment instruments. The only competitors about which they have

expressed concern – American Express and Diners Club – are the only payment

The obvious manifestation of the absence of effective competition is the fee-setting

process itself. The longstanding arrangements are characterised by secrecy, rigidity

and lack of any objective and clearly articulated methodology. Such arrangements,

in the pursuit of maximum credit card usage and scheme members’ profits, run

the serious risk of leading to overprovision of credit card services and inefficiently

high merchant service fees. Under scheme restrictions on merchant pricing,

discussed in the following Chapter, any overprovision of credit card services is

paid for by the community as a whole through the general level of prices. In the

Reserve Bank’s opinion, the current arrangements for the collective setting of

interchange fees, were they to persist, would not be in the public interest.

Community welfare would clearly be enhanced by greater competition between

payment card networks. However, because of network effects, it is very difficult

for small and/or new networks to compete with large, established ones; as the

card schemes themselves acknowledge, individual cardholders and merchants prefer

As noted in Chapter 1, regulatory authorities in some other countries are currently

reviewing credit card interchange fee arrangements from a public interest

perspective. Although these reviews are not complete, the approaches being taken

by these authorities eschew “black box” methodologies, which treat interchange

fees as a balancing device to be left entirely to negotiations between card scheme

members, in favour of transparent, cost-based rules or methodologies for

determining interchange fees. These rules or methodologies focus on the credit

card payment services, separately identified, which are provided to merchants.

In its response to the Cruickshank Report on competition in UK banking, the UK

Government concluded that, while there were respectable economic arguments

for a balancing approach, “… for established payment systems it would appear

75 See, for example, Australian Bankers’ Association (2001b and 2001c) and Visa International

(2001b).

76 Visa International (2001a), p 3.

42

that there were more damaging effects associated with a high, non-cost based

effects of inflated interchange fees identified in the Cruickshank Report included:

• high costs for merchants which in turn lead to higher prices for consumers;

• weakened incentives for issuers to cut costs through greater efficiency; and

• distortion in competition between payment instruments in favour of instruments

with artificially high interchange fees (when those interchange fees are used

to fund loyalty schemes).

Accordingly, the UK Government has announced its intention to introduce a set of

competition-oriented rules to govern participants in the UK payments system, with

one rule aimed at ensuring efficient wholesale pricing (including interchange fees).

In the latter case, the proposal is that wholesale prices be derived through a

published methodology that is based on legitimate costs, and that anticipates

achievable cost reductions.

Similarly, the European Commission has rejected the balancing approach to

determining interchange fees in favour of a cost-based methodology in its

investigations of Visa’s interchange fee arrangements in its intra-European

operations. This is discussed further below.

In the absence of a vigorous competitive environment, the Reserve Bank believes

that the public interest requires a transparent and objective methodology for the

setting of credit card interchange fees in Australia, and that the fee-setting process

be open to public scrutiny. This would give cardholders, merchants and the

community confidence in the integrity of arrangements by which a crucial

wholesale price in credit card schemes is determined. In the Reserve Bank’s view,

any methodology for determining an interchange fee should be consistent with a

set of principles that would promote more efficient and transparent pricing of

credit card services to both merchants and cardholders. These principles would

require any methodology to:

(i) provide a cost-based justification for the level of interchange fees that is

transparent to merchants, cardholders and the community in general;

(ii) be based on the credit card payment services which are provided to merchants,

and for which card issuers recover costs through interchange fees;

(iii) exclude from its calculations costs that are not related to payment network

considerations, and are therefore not relevant to interchange fee calculations;

77 HM Treasury (2000), p 29.

43

(iv) provide for different interchange fees for different types of transactions and/

or differences in the credit card payment services provided to merchants;

(v) have the data independently verified; and

(vi) be subject to regular reviews.

The international card schemes have suggested to the Reserve Bank that the

methodologies they have applied in other countries could form the basis for

interchange fee setting in Australia. However, the Australian members of the schemes

have, through the ABA, proposed a quite different approach. In contrast, retailers

have argued for the abolition of credit card interchange fees and their replacement

with a “fee for service”. These different approaches need to be assessed against the

principles set out above.

The MasterCard methodology used in other countries sees the interchange fee as

the means by which issuers recover costs for specific services provided to acquirers

issuers’ costs included in the interchange fee are:

• the cost of providing a payment guarantee, including the cost of fraud and

credit write-offs. The justification for including fraud costs is that a merchant

still receives payment from the card issuer if it accepts a credit card transaction

that the merchant is guaranteed payment by the card issuer even if the cardholder

does not repay the issuer. If the merchant itself had been extending credit, it

would have lost money in the event of customer default;

• the cost of funding the interest-free period. The justification is that provision

of interest-free credit to cardholders benefits the merchant by increasing its

sales and saving it the direct costs of providing this service itself; and

• the costs of processing transactions from acquirers. These include costs of

receiving and verifying the transaction and the cost of settlement. The

justification for including these costs is that they benefit the merchant by

enabling it to transact with customers of financial institutions other than its

own acquirer.

78 MasterCard International (2001), p 40.

79 This guarantee, however, does not apply for all credit card transactions. For “card not

present” transactions where there is no signature (for example, Internet or telephone

transactions), the merchant does not have a guarantee of payment in the event of fraud.

44

MasterCard claims that “[t]he interchange fee is then established by taking these

costs as a starting point and taking into consideration other factors, including the

need to provide incentives for widespread issuance and for merchants to accept

approach does not include other costs incurred by card issuers, such as loyalty

programs and other marketing costs, a return on capital or sunk costs; these costs

are left for issuers to recover directly from their customers.

The MasterCard methodology has been under review by competition authorities

in the United Kingdom. In September 2001, the Office of Fair Trading (OFT)

notified MasterCard/Europay that it proposed to make a decision that agreement

among MasterCard/Europay members on the level of their multilateral interchange

fee is in breach of UK competition law and does not qualify for exemption. The

OFT considers that the agreement on this fee increases retail costs and the prices

paid by consumers for goods and services. The OFT is now taking representations

The Visa methodology is used in some other countries as a basis for determining

interchange fees for domestic transactions, and in some regions for determining

international interchange fees. Drawing on the original Baxter analysis, Visa sees

the interchange fee as a financial adjustment which reduces the imbalance between

that fee that equates the acquirer’s share of total payment system costs with its

share of revenues.

Visa’s approach focuses on the costs of providing only the payment services of

credit cards; it excludes costs that are related to the provision of the revolving

credit facility. Visa states that it undertakes detailed data collection and calculations

in determining interchange fees. The Reserve Bank understands that these

calculations do not include estimates of the various demand and supply elasticities

for credit card payment services; nor do they provide for a return on capital or for

loyalty programs and marketing costs. The calculated fee is used by members as a

benchmark in deciding actual fee levels; other considerations, such as competitors’

interchange fees, different merchant sectors, innovation and incentives are also

said to be taken into account. Visa claims that its international interchange fees

have always been set below the amount calculated by its methodology.

80 MasterCard International (2001), p 40.

81 Office of Fair Trading (2001).

82 See Visa International (2001a), pp 21-22.

45

Visa has provided the Reserve Bank with summary worksheets from its review of

domestic interchange fees in Australia in the mid 1990s, but not with detailed

spreadsheets that would show how interchange fees are calculated in other regions.

In the United Kingdom, similarly, Visa did not allow any information about the

application of the Visa methodology to be published in the Cruickshank Report.

This lack of transparency makes it very difficult to assess the methodology

and whether, in particular, it can generate differential interchange fees in any

systematic way.

The Australian members of Visa have not recommended that the Visa methodology

be adopted for the determination of interchange fees in Australia. In any event,

Visa has recently abandoned its balancing approach in the case of its intra-regional

interchange fees in Europe, in response to concerns expressed by the European

Visa’s interchange fee for intra-regional transactions amounted to a collective price

agreement, which is restrictive of competition. Visa has subsequently proposed

moving to a simple cost-based methodology that would be used as an objective

benchmark against which its intra-regional interchange fees would be assessed.

The three broad categories of costs for inclusion in this methodology are identical

to the MasterCard approach – viz, the costs of providing the payment guarantee,

the interest-free period and processing costs – but details of these costs and on the

proportion that would be attributed to merchants are not available. The interchange

fee would be the lower of the fee determined by this methodology and Visa’s

proposed reduction in its weighted average interchange fees to a maximum of

0.7 per cent over five years. The European Commission has invited submissions

from interested third parties before finalising its decision on whether to respond

favourably to Visa’s revised methodology.

The ABA, on behalf of nine member banks, has proposed what it has called the

“avoidable cost” methodology for determining interchange fees. This is the third

attempt by Australian banks to propose a suitable methodology; two previous

proposals which might have formed the basis for an authorisation of interchange

early 2001 but these proposals were not submitted to the Reserve Bank.

83 European Commission (2001b).

46

The ABA describes its methodology as being based on the question “[w]hat costs

would be unavoidable if an issuer were to provide (on a sustainable basis) only

interchange fees should be no higher than the stand-alone cost of sustainably

providing the “buy now pay later” functionality, and no lower than the incremental

would provide an “envelope” for interchange fees – the designated credit card

schemes could use whatever approach they wished provided the resulting

interchange fee is not higher than the envelope.

The avoidable cost methodology does not include issuers’ costs associated with

the provision of the revolving credit facility. However, it does include a wide range

of other costs, such as fraud costs, credit losses associated with the use of the

interest-free period, operating costs, marketing, promotion and retention costs,

the payment functionality of the credit card could be passed to merchants through

the interchange fee under this methodology. The ABA argues that this avoids the

need for an “arbitrary” allocation of costs between merchants and cardholders; in

doing so, however, the avoidable cost methodology provides no incentives to issuers

The costs that would be included under the different cost-based methodologies,

including Visa’s compromise proposal to the European Commission, are summarised

in Table 2.5.

In the Reserve Bank’s judgment, none of these methodologies fully meets the

principles for interchange fee setting established earlier. Each includes costs which

are not related to payment network considerations or to specific services provided

to merchants. A number of cost categories do not meet the principles.

84 Australian Bankers’ Association (2001b), p 51.

85 The stand-alone cost is defined as “the costs for an organisation to establish and operate a

is the cost “that would be incurred if that functionality [buy now, pay later] was added to an

47

Costs associated with credit assessment, credit losses and recovery, which are

included in the MasterCard methodology, are not related to payment network

they arise out of the provision of credit facilities to cardholders, based on credit

risk assessments carried out by individual card issuers and on terms and conditions

a Details of the payment guarantee costs that would be included in the Visa methodology are not

available.

b Credit losses associated only with the use of the interest-free period.

87 At this stage, it has not been announced whether these costs would be included in payment

guarantee costs under Visa’s compromise methodology.

48

set by them. Neither the credit card schemes nor merchants have input into the

terms and conditions. The Reserve Bank agrees with this argument. In principle,

efficient pricing requires that the credit risks be incorporated into credit card

cardholders in Australia using revolving credit facilities are fully covering average

credit losses by paying interest rates well above rates on other unsecured personal

calculations, card issuers would be recovering the costs of credit losses twice.

Moreover, a pricing structure which passed average credit losses to merchants

through interchange fees would create a “moral hazard”, in that card schemes

would have an incentive to promote inefficiently low credit standards.

Although it excludes issuers’ costs associated with the provision of the revolving

credit facility, the avoidable cost methodology does include some proportion of

credit losses in the interchange fee. The ABA has argued that a proportion of these

credit losses arises from cardholders who pay no interest (ie transactors) and likens

these losses to credit losses in charge card schemes that do not have a revolving

they are likely to be very small: default on credit card debt, whether revolving or

Furthermore, unlike charge cardholders, credit cardholders do not need to default

immediately if they get into difficulties – they can choose to pay the minimum

monthly amount. For these reasons, it seems highly unlikely that non-revolvers

that suddenly default would constitute a significant group. In a different argument,

the ABA has claimed that “[w]hen a cardholder defaults on payment, the outstanding

balance may include both purchases and cash advances made in prior periods (and

that have been revolved) and purchases and cash advances made during the current

period. Therefore the costs associated with credit losses and collections relate

partially to the payment functionality of the credit card and partially to the other

revolving credit facility, they usually receive no interest-free period; they pay interest

on all purchases, even those in the current period. The issuer therefore receives

88 This point has been acknowledged by Visa International (2001a) and the Australian Retailers

Association (2001b).

89 Reserve Bank of Australia and Australian Competition and Consumer Commission (2000),

p 50.

90 Australian Bankers’ Association (2001b), p 33.

91 KPMG Consulting (2001), p 22.

92 Australian Bankers’ Association (2001b), p 77.

49

recompense for credit losses from these customers directly through the credit card

interest rate.

As with the revolving credit facility, provision of the interest-free period is a credit

service provided to cardholders on terms and conditions set exclusively by

individual card issuers; it is not related to payment network considerations. Neither

the credit card schemes nor merchants have any input into the terms and conditions

on which this service is provided. Although the interest-free period has been an

integral feature of a credit card, some card issuers in Australia offer their customers

a credit card without it, at a lower annual fee and interest rate on the revolving

credit facility. The interest-free period is clearly a benefit to cardholders, enabling

them to manage their liquidity by reducing their use of cash and their balances in

low-yielding transaction accounts. Some submissions have claimed that the

interest-free period encourages cash-constrained customers to make “impulse”

purchases at individual merchants but, as discussed earlier in this Chapter, there is

no evidence that merchants as a whole enjoy a permanent increase in sales from

credit card usage.

The ARA has pointed out that although house builders benefit when financial

institutions provide mortgages to their customers, no-one expects builders to pay

argued that recovering the costs of the interest-free period from merchants through

an interchange fee distorts consumers’ choices between a credit card and alternative

payment instruments. A customer making a purchase by debit card or cheque, and

drawing on an attached overdraft facility, does not have the costs of this overdraft

paid for by the merchants that supplied the goods. In the Reserve Bank’s view,

since the provision of the interest-free period is a matter exclusively between

individual card issuers and their customers, passing the costs of the interest-free

period to merchants through interchange fees would not meet the Reserve Bank’s

principles for interchange fee setting.

The avoidable cost methodology includes the cost of loyalty programs in the

interchange fee, on the basis that these are resource costs incurred by issuers as a

arguing for the inclusion of such costs in interchange fees; as far as the Reserve

93 Australian Retailers Association (2001b), p 7.

94 Australian Bankers’ Association (2001b), p 31.

50

Bank is aware, neither MasterCard nor Visa treat them as eligible costs in their

methodologies in any country (nor does Visa in its compromise proposal to the

European Commission).

The Reserve Bank is unconvinced by the ABA’s arguments. Loyalty programs do

impose costs on credit card issuers that offer such programs, but these costs are

not integral to the provision of payment services. The payment services of a credit

card – in particular, its “buy now, pay later” feature and guaranteed refund – have

not changed since the credit card was first introduced. Loyalty programs do not

add to these services – a cardholder receiving loyalty points cannot effect a credit

card transaction more efficiently, more speedily or more securely than a cardholder

who does not receive loyalty points. The costs of loyalty programs are a discretionary

cost for card issuers, and a number of issuers have chosen not to offer such

successful payment networks exist without loyalty schemes and, until the last few

years, so did the credit card network in Australia. Loyalty schemes are a relatively

recent ‘add on’ (they were introduced from around 1995) to an existing credit

card system in Australia that had operated successfully since its establishment.

Loyalty schemes may encourage consumers to use credit cards in preference to

other payment instruments; however, no evidence has been presented that this

results in a permanent increase in sales for merchants as a whole. Indeed, merchants

themselves are strongly critical of the use of credit card loyalty programs to

encourage credit card usage because they believe they bear the cost of these

Credit card loyalty programs in Australia are used by individual financial institutions

mainly as a means of retaining their customers. The programs are not provided by

the credit card schemes themselves and are not integral to them. For some of the

major banks, the same loyalty points are provided to customers irrespective of

which card is used, and scheme points cannot usually be transferred if a customer

wishes to remain in the same card scheme but switches to another card issuer.

One of the major banks has advised that its loyalty programs are promoted in the

bank’s interest. According to this bank, the two main objectives of its loyalty

95 Although Visa does not include the cost of loyalty programs in its interchange fee calculations

in other countries, it has recently offered the view that provision of a loyalty scheme has now

become a function of a payment system. Visa International (2001b), p 48. Elsewhere, Visa has

claimed that loyalty points are part of the payment service of a credit card in the same way

that air conditioning in a motor vehicle is a resource cost associated with the provision of

motoring services. This analogy is incorrect; loyalty points are analogous to a rebate on

running costs for the use of a motor vehicle. See Visa International (2001a), pp 23-24.

96 Australian Retailers Association (2001b) and Shell (2001), p 13.

51

programs are the retention of existing customers and maintenance of its competitive

position in the market. Neither of these objectives relates to the provision of

payment services or to payment network effects.

In the Reserve Bank’s view, loyalty points are price discounts or rebates. They are

transfers to credit cardholders rather than costs associated with the provision of

payment card services, and hence are not eligible for inclusion in the determination

of interchange fees. This view is supported by Gans and King, consultants to National

Australia Bank, and is consistent with the treatment of rebates in recent theoretical

attention to the consequences that would arise if the costs of loyalty programs

effective limit on the ability of issuers to impose inefficiently high interchange

fees to fund loyalty programs, since the cost of the programs would be incorporated

in the calculation of allowable interchange fees.

The avoidable cost methodology includes in the interchange fee the costs of

providing cardholder services, such as the printing and distribution of statements

and the acceptance of repayments. These costs are unrelated to the payment services

of a credit card or to payment network considerations. They are pure account services

to cardholders, just as they are when provided in conjunction with other payment

instruments.

The avoidable cost methodology includes in the interchange fee a return on the

capital committed by card issuers and an allowance for the sunk costs of issuers,

in the form of past losses on credit card issuing. Although these two concepts are

different in principle, the argument for their inclusion amounts to the same thing

– the interchange fee should have built into it a rate of return on credit card

97 See Gans and King (2001d), p 32 and Katz (2001), p 35. In his critical analysis of

interchange fees, Frankel has observed that banks “… pass some of the additional profits

[generated by interchange fees] on to credit card customers in the form of rebates”.

Frankel (1998), p 344.

98 Katz (2001), p 35.

99 “From a practical perspective, sunk costs are typically reflected in the return on equity capital

that is earned to recognize the risk of the business and the life cycle return on capital

requirements.” Australian Bankers’ Association (2001b), p 77.

52

All firms need to commit capital to support their activities and require a sufficient

return on that capital if they are to remain in the business. If the return on capital

is too low, the capital would be better employed elsewhere. The concept of an

allowance for past losses is slightly different. It recognises that firms may incur

losses in the early years of an investment in the expectation of building the business

and realising profits in the future that would offset the earlier losses.

The Reserve Bank acknowledges that credit card issuers have undertaken a

substantial investment in the development of credit card networks and that they

are entitled to earn a return, both on the capital currently committed and on past

investments. It does not agree, however, that these returns should be earned entirely

through the interchange fee, as the avoidable cost methodology requires. There

would be logic in individual issuers seeking from merchants a return on the capital

committed to providing payment services to merchants (eg that part of the capital

costs of chip technology aimed at fraud prevention), although it is not clear how

different “hurdle” rates of return for different issuers could be credibly averaged

for inclusion in an interchange fee.

However, there is no obvious logic in the argument that card issuers should seek

through an interchange fee passed onto merchants. Such a process would amount

to card scheme members collectively underwriting an industry average rate of return

for credit card issuing. To include it in any standard on interchange fees would

imply an official endorsement of that average. Issuers have revenue sources other

than interchange fees and are able to earn returns through the pricing of their

card services to cardholders, just as they do for other financial products. In this

way, the rate of return for an individual issuer is largely subject to competitive

forces.

The Reserve Bank’s views on the treatment of the costs of capital and sunk costs is

consistent with the approach taken by MasterCard and Visa and is supported by

Gans and King. The latter note that:

“If interchange fees for issuers are reduced because their sunk

investment costs are not taken into account, issuers will be able to

recover those costs from other revenue sources. This is precisely

because all issuers receive a common interchange fee and so changes

in that fee would, for the most part, not impact on their profits in

competition with one another.

In effect, issuers and acquirers will earn their sunk entry costs in the

marketplace … As in all markets, firms will enter or exit issuing and

acquiring only if they can earn a return on sunk expenditures and

53

hence, there is no further need for regulatory underwriting of such

In contrast to the different methodologies discussed above, the ARA has argued

for the abolition of interchange fees in the credit card system in Australia and

the infrastructure investment and actual costs incurred by those parties, including

merchants, involved in the processing of credit card transactions.

Under the ARA proposal, which has been explained to the Reserve Bank in

consultations, the cardholder would pay for those costs that the issuer incurs on

its behalf, including the cost of the interest-free period, credit losses and account

maintenance costs. The issuer would negotiate to pay the acquirer a fee for access

to merchants and, where the merchant provides the infrastructure, this fee would

pass to the merchant. The merchant would pay the acquirer for settlement services

and any other costs relating to its access to the network.

The underlying logic of this proposal is that the providers of the network

infrastructure (acquirers and sometimes merchants) ensure cardholders and

merchants have access to a payment system and that providers should be

recompensed for this. That same logic implies that card issuers do not provide

payment services for which merchants are the main beneficiary, hence eschewing

the need for an interchange fee. It also implies that negotiations between issuers

and acquirers would be bilateral, as they are in Australia’s debit card system.

The ARA proposal has strong similarities with the justifications for the flow of

interchange fees from issuers to acquirers (and some merchants) in Australia’s

debit card system. The proposal would represent a major departure from

long-established credit card arrangements, for which there is no precedent in any

country. It could also pose substantial practical difficulties. Many of the difficulties

the Reserve Bank has identified with interchange fee setting for credit cards – the

rigidity of fees and the lack of transparency in fee setting – are present, if not

worse, in systems with bilateral negotiations, as the ATM and debit card systems

in Australia have illustrated. Furthermore, fee setting based on a web of bilateral

agreements could make access difficult for small participants. Under current credit

card scheme arrangements, membership criteria are at least objective.

100 Gans and King (2001d), pp 33-34.

101 Australian Retailers Association (2001b).

54

In the Reserve Bank’s opinion, current arrangements for the collective setting of

interchange fees in the designated credit card schemes are not in the public interest.

As noted earlier, these arrangements are characterised by their rigidity, lack of

transparency and absence of any clearly articulated methodology, and they have

been able to persist because of the absence of strong competitive conditions. Given

the major changes that have taken place in technology, credit card volumes and

costs over the period, it would be purely fortuitous that a particular interchange

fee set by Bankcard in 1974, and that was also adopted by the international card

schemes in 1993, results in efficient pricing of credit card services to cardholders

and merchants, and maximises community welfare, in 2001. The card schemes

and their members have proposed alternative methodologies for setting interchange

fees, but these do not meet the principles which the Reserve Bank believes are

needed to promote efficiency and transparency in fee setting. The methodologies

would charge to merchants, and to the community as a whole, credit card costs

that arise out of the provision of specific credit card services to cardholders.

For these reasons, the Reserve Bank has concluded that a standard is needed, in

the public interest, that would enshrine its principles for interchange fee setting.

The standard would apply to participants in the three designated credit card

The Reserve Bank’s draft standard seeks to ensure that interchange fees in designated

credit card schemes are calculated on the basis of an objective, transparent and

cost-based methodology and are regularly reviewed. The methodology is based on

the credit card payment services which are provided to merchants, and for which

card issuers recover costs through interchange fees. In the Reserve Bank’s opinion,

only two categories of issuers’ costs are eligible for inclusion in the calculation.

These are:

(i) costs incurred for processing transactions received from other scheme

members that would not be incurred if the issuer were also the acquirer.

These are costs associated with operating the credit card payment network

and include the costs of receiving, verifying, reconciling and settlement of

transactions from other scheme members. The costs would be separately

calculated for electronic and paper-based transactions; and

102 The ABA has submitted that, if the Reserve Bank is to use its payments system powers,

interchange fee setting should be regulated via an access regime rather than a standard.

Australian Bankers’ Association (2001b), Chapter 2. The Reserve Bank, drawing on advice

from senior counsel, does not accept this interpretation of its powers.

55

(ii) costs for fraud and fraud prevention and authorisation incurred in providing

any payment guarantees. The payment guarantee is a payment service provided

by a credit card of which merchants are the main beneficiary. Again, costs

will be separately calculated for electronic and paper-based transactions.

However, where issuers can charge fraud costs back to the merchant, such as

in “card not present” transactions, these costs would not be included in the

interchange fee (nor presumably in a merchant service fee); to do so would be double counting.

In principle, the payment guarantee could be “unbundled” from other credit card

payment services and provided to merchants by third parties, such as insurance

companies. At this point, there are no signs of alternative suppliers of this product

emerging in Australia. However, if such a market were to develop, arguments for

inclusion of the costs of the payment guarantee in the interchange fee would need

to be revisited.

The draft standard provides for differential interchange fees for different types of

transactions (paper vs electronic) and differences in the credit card payment services

provided to merchants (payment guarantee vs no payment guarantee).

The draft standard requires that interchange fees in a designated credit card scheme

be based on the eligible costs of participants accounting for at least 90 per cent of

the value of transactions in that scheme. Costs would be provided to an independent

expert agreed to by the Reserve Bank, who would calculate interchange fees for

that scheme on a weighted average basis. Interchange fees so calculated would be

to “post” lower interchange fees. The data and the interchange fee calculations of

the independent expert must be provided to the Reserve Bank, which would satisfy

itself that the data were consistent with the standard. In the interests of transparency,

each designated credit card scheme must also publish the data (in aggregate form)

and its interchange fees. Interchange fees must be reviewed by the designated credit

card schemes if the Reserve Bank considered that changes in costs warranted a

review or, in any event, on a three-year cycle.

The draft standard also aims to provide legal certainty to the designated credit

card schemes and their members. As noted earlier, the ACCC has advised that the

collective setting of interchange fees is a breach of the price-fixing prohibitions

the Reserve Bank and the ACCC stated that it was their intention to ensure that

56

standard does not require the credit card schemes or their members to act in a

The draft standard on wholesale fee setting is set out below.

57

2. This Standard applies to the three credit card systems designated on

12 April 2001 by the Reserve Bank of Australia under Section 11 of the

(i) the credit card system operated within Australia known as the

Bankcard Scheme;

(ii) the credit card system operated within Australia known as the

MasterCard System or MasterCard Network Card System; and

(iii) the credit card system operated within Australia known as the Visa

System or the Visa Network Card System,

each referred to as follows as a Scheme.

3. In this Standard:

an “acquirer” provides services to merchants to allow the merchant to

accept a Scheme’s credit cards;

“credit card transaction” or “transaction” means a transaction between a

credit card holder and a merchant involving the purchase of goods or

services on credit by that credit card holder using a credit card;

58

“electronic transaction” means a credit card transaction for which

authorisation is obtained by the merchant electronically;

“financial year” is the 12 month period ending 30 June;

an “issuer” issues a Scheme’s credit cards to its customers;

“nominated Scheme participants” are those issuers in a Scheme that issued,

in aggregate, credit cards which were used in at least 90 per cent of credit

card transactions by value in that Scheme in the financial year prior to

the year in which interchange fees must be calculated;

“payment guarantee” means a guarantee provided to a merchant in respect

of a credit card transaction;

“rules of a Scheme” or “rules” include the constitution of a Scheme, rules,

by-laws, procedures or any arrangement in relation to a Scheme by which

participants in the Scheme in Australia may consider themselves bound;

“Scheme Administrator” is the administrator of the Scheme, if any;

a “Scheme’s credit card” is a credit card issued in accordance with the

rules of that Scheme;

use of a credit card includes use of a credit card number.

4. This Standard refers to wholesale fees, known as “interchange” fees, which

are paid to an issuer in Australia in a Scheme by an acquirer in Australia

in that Scheme in relation to a credit card transaction.

5. This Standard is to be interpreted:

• in accordance with its objective; and

• by looking beyond form to substance.

6. This Standard comes into force on [ ].

7. Interchange fees must be based on credit card payment services which

are provided to merchants. The only amounts that can be included in the

calculation of an interchange fee in a Scheme are the following costs in

respect of that scheme:

(i) issuers’ costs incurred in processing credit card transactions received

from an acquirer that would not be incurred if the issuer was also

59

the acquirer in those transactions. This category includes the costs

of receiving, verifying, reconciling and settling such transactions;

(ii) issuers’ costs incurred in respect of fraud and fraud prevention; and

(iii) issuers’ costs incurred in providing authorisation of credit card

transactions,

8. In a Scheme separate interchange fees must apply to:

(i) electronic transactions that are the subject of a payment guarantee;

(ii) transactions (other than electronic transactions) that are the subject

of a payment guarantee;

(iii) transactions (other than electronic transactions) that are not the

subject of a payment guarantee; and

(iv) electronic transactions that are not the subject of a payment guarantee,

to take into account the difference in eligible costs incurred by the issuer.

9. Data on eligible costs of each nominated Scheme participant for each

type of specified transaction must be provided by that participant to an

independent expert agreed to by the Reserve Bank of Australia. The data

must be drawn from accounting records of the nominated Scheme

participant for the previous financial year prepared in accordance with

generally accepted accounting standards.

10. The expert must review the data to determine if the costs included are

eligible costs and use the data on eligible costs to calculate an interchange

fee for each type of specified transaction. The interchange fee for each

type of specified transaction must be calculated as a weighted average of

the nominated Scheme participants’ eligible costs for that specified

transaction. The weights to be used are the shares of each nominated

Scheme participant in the total value of the transactions undertaken on

credit cards issued by all the nominated Scheme participants in the

financial year to which the data relates.

60

11. The Scheme Administrator or, if none, the nominated Scheme participants,

must provide the Reserve Bank of Australia with the data on eligible costs

used by the independent expert and the interchange fees calculated by

that expert.

12. The Scheme Administrator or, if none, participants in the Scheme must

publish in a national newspaper and permanently publish on the Scheme

Administrator’s website, or, if none, on another relevant website:

(i) the aggregate data used by the expert to calculate interchange fees;

and

(ii) the interchange fees calculated by the expert in accordance with

paragraph 10 of this Standard.

13. Any interchange fees charged or paid by a participant in respect of a

specified transaction in a Scheme must not exceed the interchange fee

calculated by the expert for that specified transaction in accordance with

this Standard.

14. The interchange fees of a Scheme must be calculated and published in

accordance with this Standard within [3] months after this Standard comes

into force.

15. The interchange fees must be recalculated and published in accordance

with this Standard every three years from the date this Standard comes

into force. If the Reserve Bank of Australia considers that changes in

costs warrant an earlier recalculation of interchange fees, it can so advise

the Administrator of a Scheme or, if none, each of the participants in the

Scheme. A recalculation of interchange fees in accordance with this

Standard must be carried out and completed and any new interchange

fee published in accordance with this Standard within [3] months of that

advice.

Reserve Bank of Australia

SYDNEY

61

The MasterCard and Visa credit card schemes have regulations, enforced by their

respective Australian members, that prevent merchants in Australia charging

customers who use these credit cards more than they charge customers that use

less costly payment instruments. These restrictions are absent in the Bankcard

scheme but they are also imposed by the three party card schemes, American Express

and Diners Club. The restrictions are so well entrenched that some merchants

mistakenly believe they have been imposed under legislation; this is not so.

The restrictions are commonly known as the “no surcharge” rule. This is a

misleading description because the use of the term “surcharge” implies that the

restriction is against imposing a second or additional transaction charge on a person

using a credit card, whereas it prevents charging any transaction fee at all. Thus, it

prevents merchants recovering from cardholders, on a “fee for service” basis, the

costs they incur when they accept credit cards for payments rather than lower-cost

payment instruments. As a consequence, the merchant service fees charged to

merchants by credit card acquirers are passed onto all consumers – not just those

using credit cards – in the form of higher prices of goods and services. Prices paid

for goods and services by users of lower-cost payment instruments are higher, and

those paid by credit cardholders lower, than would otherwise be the case.

Earlier official inquiries into scheme restrictions on merchant pricing in Australia

have unanimously agreed that the restrictions are anti-competitive and against the

public interest. In 1980, the Trade Practices Commission (TPC), the predecessor

of the ACCC, disallowed the restrictions when it granted authorisation for the

Bankcard scheme; the TPC found that the restrictions prevented merchants from

adopting variable pricing techniques as a method of competing with other

reached by the Martin Committee in its 1991 report into banking and

The Prices Surveillance Authority concluded that “[w]hile many retailers may choose

103 Bankcard Scheme: Interbank Agreement (1980) ATPR (Com.), 50-100, at 52, 169. Bankcard’s

authorisation was revoked by the Trade Practices Commission in 1990.

104 House of Representatives Standing Committee on Finance and Public Administration (1991),

pp 365-366.

62

not to dual price given the freedom to do so, an in principle case, nonetheless,

exists for ensuring efficient pricing by giving merchants the freedom to set prices

reflecting the costs involved in effecting transactions, including methods of

merchants to charge different prices for accepting different payment instruments,

but the credit laws do not prevent credit card schemes imposing restrictions, which

are enforced by card scheme members, which prevent merchants from exercising

this freedom.

The Joint Study also concluded that restrictions on merchant pricing suppress

important signals to end-users about the costs of the credit card network and that

such restrictions are not desirable. Merchants “… should not be prevented by the

credit card schemes from passing on some or all of the merchant service fee through

responded that there are benefits to the community flowing from these restrictions

and that the restrictions should be allowed to stand.

This Chapter considers whether the restrictions imposed by the credit card (and

charge card) schemes are in the public interest. After detailing the restrictions, it

explains their impact on community welfare and the public interest concerns that

are raised. It then analyses the main arguments made by the card schemes and

their members against abolishing the restrictions. In the Reserve Bank’s judgment,

restrictions on merchant pricing are not consistent with the promotion of efficiency

and competition in the Australian payments system. Accordingly, it has decided to

determine a standard for merchant pricing to ensure that merchants are free to

recover from cardholders the costs of accepting credit cards. The draft standard is

discussed in the concluding section.

The restrictions on merchant pricing imposed by MasterCard and Visa are set out

in their respective international rules and apply in that form to Australia.

The MasterCard rules state that:

“The merchant shall not directly or indirectly require any MasterCard

cardholder to pay a surcharge, to pay any part of any merchant

discount, whether through any increase in price or otherwise, or to

pay any contemporaneous finance charge in connection with the

transaction in which a MasterCard card is used. A surcharge is any

106 Prices Surveillance Authority (1992), p 123.

107 Reserve Bank of Australia and Australian Competition and Consumer Commission (2000), p 55.

63

fee, charged directly or indirectly, deemed by this Corporation to be

associated with the use of a MasterCard card that is not charged if

another payment method is used … . The prohibitions of this

subsection (14) do not prohibit discounts for payments in cash, or

for charges … that are charged to the cardholder regardless of the

The Visa rules state that:

• Add any surcharges to Transactions, unless local law expressly

requires that a Merchant be permitted to impose a surcharge.

Any surcharge amount, if allowed, must be included in the

The rules of both schemes permit cash discounts in Australia, as they do in the

United States. This is in contrast to many European countries where “no

discrimination” rules imposed by the card schemes prevent cash discounts as well

as surcharges for card use. Both schemes also acknowledge that their rules on

merchant pricing are not valid if the laws of the relevant jurisdiction forbid it.

Other countries have prohibited such rules on anti-competitive grounds. The rule

has been prohibited in the United Kingdom since 1991, in the Netherlands since

1994 and in Sweden since 1995.

on trade. They deny merchants the freedom to set prices that promote the

competitiveness of their business. No other supplier of goods or services to

merchants seeks – or is legally able – to restrain them from passing on the costs of

these services to customers who use them. The anti-competitive nature of these

restrictions was a major factor in the decisions of competition authorities to prohibit

them in the three European countries noted above. In the Netherlands, for example,

the authorities judged that merchant pricing freedom was essential for safeguarding

Scheme restrictions on merchant pricing inhibit the normal market mechanisms

and have two important economic effects. The first is that the general level of prices

is higher than it otherwise would be, and consumers who do not use credit cards

108 Under 9.04 b (14) of the MasterCard International Bylaws and Rules.

109 Under 5.2.C of the Visa International Operating Regulations, General Rules. Prohibitions.

110 Correspondence from NMa, the Netherlands’ competition authority, 12 July 2001.

64

pay more than they would otherwise. The second is that by distorting the relative

prices of payment services to consumers, the restrictions do not promote efficient

resource allocation and maximum community welfare.

Scheme restrictions on merchant pricing require merchants to charge the same

price to consumers irrespective of the payment instrument used. Merchants

therefore average their costs from different payment instruments to determine their

prices. If customers switch from lower-cost alternatives to credit cards, which have

been shown to be a higher-cost payment instrument for merchants to accept,

merchants face an increase in total costs. As discussed in Chapter 2, there is no

evidence to suggest that this increase in costs would be offset by higher sales for

merchants as a whole. Merchants therefore pass the increase in their total costs

into the prices of goods and services. As a consequence, scheme restrictions on

merchant pricing mean that increases in credit card usage result in a higher general

level of prices of goods and services. Consumers who use lower-cost payment

instruments pay a higher price for goods and services than they would otherwise,

and therefore contribute indirectly to the costs of credit card schemes.

The potential for consumers who do not use credit cards to be harmed by scheme

restrictions on merchant pricing is recognised in the recent theoretical literature

on credit card networks. The article by Rochet and Tirole demonstrates that the no

surcharge rule gives the interchange fee its ability to affect the size of the credit

card system: “[t]he no-surcharge rule leads, as one would expect, to a redistribution

optimal interchange fees are equal – in a context of strong merchant resistance to

credit cards – removing the no surcharge rule would lead to an underprovision of

credit cards, reducing the community’s welfare. However, if merchants have limited

resistance to accepting credit cards – the more realistic assumption – the interchange

fee set by an issuer-controlled credit card scheme will lead to the overprovision of

credit card services; in this context, removing the no surcharge rule would reduce

credit card usage and increase the community’s welfare.

Gans and King also note the argument that “cash and cheque customers are

implicitly cross-subsidising card customers” and conclude that “up to a point, by

increasing the interchange fee a credit card association with market power is able

111 Rochet and Tirole (2000), p 18.

112 Gans and King (2001a), pp 106-107 and (2001d), p 18.

65

is overstated because merchants are able to offer cash discounts; to the extent they

do so, rents extracted from cash customers and customers using other lower-cost

payment methods, would be reduced. In their analysis of the welfare implications

of the no surcharge rule, Schwartz and Vincent see the rule as the means by which

a credit card scheme can indirectly “tax” purchases made by cash customers. The

rule enables the card scheme to raise the merchant service fee which in turn

increases prices to all consumers. However, when rebates (such as loyalty points)

are offered to cardholders, the impact of the no surcharge rule on merchant pricing

is magnified. Issuers can provide rebates to boost credit card use and raise fees to

merchants through the interchange fee, knowing that any resulting increase in

prices must apply equally to cash customers. “Rebates thus misallocate transactions

Schwartz and Vincent also note that it is not in the interest of credit card scheme

members to set merchant service fees so high that cash customers, observing the

high prices, choose not to shop at merchants that accept credit cards “since

As an empirical matter, the likely magnitude of the impact of the no surcharge

rule on the general level of prices in Australia is not easy to determine. The impact

is diffused over a wide range of markets, in which varying mixes of payment

instruments may be used, and over millions of consumers undertaking a myriad

of transactions. In total, however, the effect is likely to be significant. The Joint

Study found that the average merchant service fee in Australia is around 1.8 per cent

of the value of credit card transactions; it is this fee, generating revenue to card

scheme members of around $1.5 billion a year, that is passed into price levels,

depending on supply and demand conditions in each market.

In its study of the credit card system in the United States, the Board of Governors

of the US Federal Reserve System found that US consumers did pay a higher price

than would be paid in the absence of credit cards. “As a result it can be said that

cash buyers, at least to some extent, subsidize credit card users by paying identical

the relatively small share of sales transacted by credit cards at that time (1983).

(The share of retail sales made using credit and charge cards in Australia, estimated

113 Schwartz and Vincent (2000), p 3.

115 Board of Governors of the Federal Reserve System (1983), p 8.

116 Australian Retailers Association (2001b).

66

cent that was used by the Board in its study.) In its report on credit card services in

the United Kingdom, the Monopolies and Mergers Commission also reached the

conclusion that credit cardholders were subsidised by customers who do not use

A number of submissions have challenged the argument that restrictions on

merchant pricing give rise to cross-subsidisation of credit cardholders by customers

group of consumers is greater than the incremental cost of selling to that group,

there is no cross-subsidy from another group of consumers – prices are said to be

is greater than the incremental cost per unit associated with sales to these

cardholders, there is no subsidy from customers who do not use credit cards. The

conclusion follows that, since merchants are prepared to accept credit cards, the

price must be above incremental cost per unit and there is no cross-subsidy.

In the Reserve Bank’s opinion, the focus on this technical definition of cross-subsidy

does not address the public interest concern that consumers who do not use credit

cards are harmed by scheme restrictions on merchant pricing. That harm arises

because those consumers pay higher retail prices because other consumers – facing

distorted price signals – choose to use a relatively costly payment instrument. In

reviewing this argument, Katz has concluded that:

“… what matters for consumer welfare and efficiency is what actually

happens, not what labels are attached to the effects … The cited

neither a necessary nor sufficient test for economic efficiency. By

distorting relative prices, the no-surcharge rule can harm economic

efficiency even if all prices are above incremental costs. These effects

117 “We have considered whether the payment of MSCs [Merchant Service Charges] had caused

price increases and whether there is a measure of subsidisation of credit card users by those

shoppers who still do not use them. Clearly in principle this could be the case. But to the

extent that traders give discounts to their customers who do not use credit cards (which

could be a consequence of abolishing the No Discrimination rule) such subsidisation would

be reduced.” Monopolies and Mergers Commission (1989), p 161.

118 See, for example, Australian Bankers’ Association (2001b), Commonwealth Bank (2000),

Australia and New Zealand Banking Group (2001a) and Visa International (2001a).

119 Faulhaber (1975).

120 The incremental cost associated with a group of consumers is defined as the difference in

total costs when the merchant serves that group and all other existing customers and total

costs when the merchant serves only the other existing customers.

67

have two sources. One is from distortions in the use of alternative

payment mechanisms. The other is from distortions in the retail

purchases made by consumers not using the credit or charge card at

Scheme restrictions on merchant pricing suppress price signals to consumers about

the costs of different types of payment instruments. Since they do not bear any of

the costs imposed on merchants when they use their credit card, cardholders have

no incentive to make an efficient choice between payment instruments. The price

signals are further distorted for credit cardholders in loyalty programs, who are

paid a rebate to use credit cards in preference to lower-cost payment instruments.

Table 3.1 compares the costs of various card-based payment instruments and the

fees typically levied by Australian financial institutions, drawing on data from the

Joint Study; in the case of credit cards, the costs refer only to the provision of

payment services and not the revolving credit facility. Consumers using debit cards

(EFTPOS) face a fee of around $0.50 for transactions beyond the fee-free threshold,

broadly in line with the average costs of providing debit card services. The average

$, per $100 transaction

a For transactions beyond the fee-free threshold.

b Does not allow for a difference in switching costs between own ATM and foreign ATM

withdrawals.

c Includes costs of interest-free period and loyalty points.

Source: Reserve Bank of Australia and Australian Competition and Consumer Commission (2000)

121 Katz (2001), pp 41-42.

68

cost of providing a $100 credit card transaction, in contrast, is around $2.00.

a loyalty program the benefit is equivalent to around $0.42 from use of the

interest-free period, while those in loyalty programs receive an incentive of up to

$1.04 (measured as the cost to the card issuer) for using their credit cards for an

average size transaction.

Current price signals are therefore encouraging the use of a relatively high-cost

payment instrument over lower-cost alternatives. This structure of incentives is

not, in the Reserve Bank’s opinion, conducive to allocative efficiency in the

Australian payments system. As noted in Chapter 1, allocative efficiency focuses

on the relationship between inputs and outputs; allocative efficiency is increased

if a given level of output can be produced with fewer resources. Payment

instruments are used so that the consumption of goods and services can take place,

but the payment instruments themselves cannot, for the reasons discussed in

Chapter 2, generate a permanent increase in consumption. If price signals direct

resources into producing relatively high-cost payment instruments rather than

lower-cost alternatives, average costs in the payments system are higher and the

resources that can be directed into other productive uses are reduced. As a

consequence, output and community welfare are lower than they would be if price

signals were more efficient.

Although the credit card is a higher cost payment instrument, some submissions

have argued that the credit card generates greater benefits than other instruments

and therefore community welfare will be higher with increased use of credit cards.

The claim is that “… it is clear that consumers much prefer credit cards to debit

empirical support is provided for this claim, and it is impossible to verify since

institutions changed incentives through the introduction of loyalty programs for

credit cards, use of debit cards had been expanding more strongly than credit

cards; moreover, despite the current incentives, debit cards are still a widely used

payment instrument.

Submissions to the Reserve Bank have claimed that scheme restrictions on

merchants’ ability to recover costs can be justified as being in the public interest

and should be allowed to remain. The justifications take three main forms:

122 Visa International (2001a), p 17.

69

• the restrictions are needed to ensure that network externalities in credit card

schemes are realised;

• abolishing the restrictions would have limited impact in any event because

merchants will not choose to charge differential prices; and

• consumers will be confused by differential prices or may be exploited by

merchants.

The first two of these arguments, although sometimes quoted in the same

submissions, are largely contradictory.

As discussed in Chapter 2, the network externalities argument states that credit

card schemes provide benefits to consumers and merchants that would not be

realised if cardholders faced the full costs incurred by card issuers. On this argument,

an interchange fee paid to issuers by acquirers (and passed onto merchants) ensures

that these unrealised benefits are captured by allowing issuers to subsidise

cardholders; in this way, growth of the scheme is encouraged. If there are no

restrictions on their pricing behaviour, however, merchants will pass the cost of

accepting credit cards onto cardholders, who will therefore face the full costs of

the scheme. Some cardholders may choose not to join the scheme while others

may reduce their usage. As a consequence, the credit card scheme will not reach

The Reserve Bank considered the network externalities argument in detail in

Chapter 2, and found it unconvincing. Two of the reasons for that judgment are

equally relevant to assessing this particular justification for scheme restrictions on

merchant pricing.

First, the benefits of credit card use have been overstated. The claim made is that

merchants benefit from lower transactions costs and higher sales. However, the

evidence discussed in Chapter 2 suggests that credit card usage actually increases

transactions costs for merchants. Moreover, no evidence was provided that credit

card usage leads to a permanent increase in sales for merchants as a whole that

would offset their higher transactions costs.

Secondly, even if there are potential network externalities in credit card schemes,

the price mechanism may be able to internalise some of them. Chapter 2 showed

that if merchants do face higher transactions costs from credit card use (after

allowing for any merchant benefits), charging a higher price to credit cardholders

123 Visa International (2001a).

70

than for other consumers would ensure that consumers faced the social costs of

different payment instruments. Where merchants have the freedom to charge

differential prices for accepting different payment instruments, the market will

only on the potential impact on credit cardholders, the submissions have failed to

acknowledge that removal of scheme restrictions on merchant pricing might

encourage more merchants to accept credit cards. Merchants that had previously

refused to accept credit cards because they perceived the costs to be too high might

than facing an “all or nothing” choice in accepting credit cards, merchants would

have the freedom to negotiate the terms on which they were prepared to accept

these cards. Some merchants might still refuse to accept credit cards if the fixed

costs of doing so were very high; however, annual costs of around $300 per year

for a credit card terminal are unlikely to be a serious deterrent, particularly since

Visa has offered two other perspectives on network benefits to justify scheme

restrictions on merchant pricing. First, it quotes a theoretical model that shows

that, under particular parameter values, removal of the no surcharge rule would

depends on certain stylised assumptions about consumer demand – that consumers

purchase a fixed number of goods each period and place the same value on each

purchase, and that consumers as a whole make a greater volume of purchases

when credit cards are accepted (for which no evidence is provided). As a

consequence, the no surcharge rule in this model does not create any efficiency

losses for consumers that do not use credit cards, and removal of that rule leads to

the collapse of the credit card system.

Katz has demonstrated that this result “… is an artifact of an extreme assumption

experience of countries where differential pricing by merchants is permitted. The

credit card system has continued to expand in the United Kingdom, despite

124 “… in some circumstances, rather than simply undermining the use of interchange fees,

merchant surcharges are a substitute for interchange fees that ensure the internalization of

what would otherwise be externalities.” Katz (2001), p 46.

125 Rochet and Tirole note that “When merchants are allowed to apply card surcharges, their

accepting the card is no longer an issue.” Rochet and Tirole (2000), p 18.

126 Australian Retailers Association (2001a).

127 Wright (2000).

128 Katz (2001), p 21 and pp 55-57.

71

prohibition of the no discrimination rule in 1991, in Australia despite amendments

to credit laws in 1993 that allow discounts for cash, and in the Netherlands and

Sweden despite prohibition of the no discrimination rule in the mid 1990s.

Visa’s second argument to demonstrate the desirability of scheme restrictions on

merchant pricing uses a car park in a shopping centre as an analogy for the credit

since it attracts customers to the shopping centre; merchants in the centre gain

from the patronage and customers who do not use the car park still benefit from

the establishment and ongoing viability of the shopping centre. Nonetheless, the

provision of parking is costly, and this will be reflected in the rents charged to

merchants by the shopping centre and passed onto all customers using the centre

in higher retail prices. An individual merchant may not want to pay for the cost of

the car park and, if it had the ability to do so, might attempt to recover this cost

from customers that use the parking facility. Merchants in the centre as a group,

however, would not want this to occur since it would deter shoppers from coming

to the shopping centre and defeat the purpose of the free parking. “To solve this

free rider problem, the centre owner will require that all the merchants contribute

to the cost, and if the technology to surcharge customers for car parking existed,

that such a rule ensures both shoppers and merchants at the centre are better off.

In the Reserve Bank’s view, the car park analogy is unconvincing and is subject to

the same fallacy of composition as the claims that higher credit card sales for

individual merchants mean higher sales for merchants as a whole. Free parking

does not increase shopping for the community as a whole; it is used by shopping

centres as a strategic device for attracting shoppers from other centres. If all shopping

centres reacted by providing free parking, there would simply be a new equilibrium

in the economy at the same level of sales, but with higher costs. Consumers who

do not use parking facilities at any centre would, as a group, face higher retail

prices.

Another misleading parallel concerns the extent of competition between shopping

centres and within the credit card market in Australia. There is competition among

shopping centre owners and customers can choose to shop in centres with free

parking, higher rents and perhaps higher prices or in centres with no free parking,

lower rents and perhaps lower prices. This competitive market is not analogous to

the designated credit card schemes in Australia, which are characterised by

overlapping governance arrangements and lack of effective competition. Credit

129 Visa International (2001a), pp 26-29.

72

card acceptance is so widespread that, in reality, consumers have limited choice of

“cash only” merchants.

Finally, if the analogy were credible, it would suggest that even if individual

merchants wanted to recover the costs of accepting credit cards, merchants as a

whole would support a no surcharge rule binding on individual merchants because

they would expect it to boost aggregate sales. Merchant groups in Australia, however,

do not support this view. The ARA and the Restaurant and Catering Association of

Australia, both bodies representing large groups of merchants, have argued that

merchants should be able, if they wish, to recover the costs of accepting credit

merchant pricing benefit them as a group.

A more appropriate analogy for the no surcharge rule would be one based on

trucking companies that provide home delivery on behalf of stores. Traditionally,

many stores provided their own delivery service, often free of charge, but

increasingly this service has been outsourced to trucking companies and explicitly

charged for by the store (ie the service has been “unbundled”). The no surcharge

rule is analogous to a situation in which all trucking companies throughout Australia

collectively agreed to prevent individual companies from providing services to

stores that passed explicit delivery charges onto customers using the service. Stores

would therefore have to include delivery costs in prices to all customers, whether

or not they used the service. The trucking companies would benefit from this

prohibition because more customers might use a delivery service which appeared

“free”; the trucking companies might even argue that merchants as a whole would

also benefit by being able to sell a larger number of bulky goods. However, the

distortions from such arrangements are obvious. Customers who have no need for

the delivery service still pay part of the cost through higher prices. In addition,

since customers do not face the cost of delivery, they may use the service for items

they would otherwise choose to pick up or carry home themselves, leading to an

inefficiently high use of resources in delivery services. One could even imagine

that the trucking companies would like to promote use of their services by

providing rebates or reward points to the final customers.

The justification for scheme restrictions on merchant pricing presented above argues

that they are essential for the viability and expansion of credit card networks. The

second justification is that abolishing the restrictions would have no effect in any

131 Australian Retailers Association (2001b) and Restaurant and Catering Association of Australia

(2001).

73

event because merchants will not choose to charge differential prices to

possible in Australia, there is no need to allow merchants to recover their credit

card costs on a “fee for service” basis because such fees are economically equivalent

Set side by side, the two justifications are contradictory. If removal of scheme

restrictions on merchant pricing would have little effect on credit card usage and

network size, it follows that the restrictions are redundant and, like unnecessary

regulation in any form, can safely be abolished.

No surcharge rules (or their equivalent) have been prohibited by competition

authorities in at least three overseas countries: the United Kingdom, the Netherlands

and Sweden. Studies for the European Commission have shown that a limited

number of merchants in both the Netherlands and Sweden charge for credit card

use. In the Netherlands, nine per cent of a sample of 310 merchants charged a

higher price to credit cardholders and another 10 per cent offered discounts for

cash. In some industries, price differentiation was more prevalent than in others:

25 per cent of petrol stations surveyed and 22 per cent of travel agencies surveyed

indicated that they charged credit cardholders a fee to recover their costs. The level

Sweden, only five per cent of a sample of 300 merchants charged credit cardholders

a fee for using their credit card and around 1.5 per cent offered discounts for cash.

Merchants that charged a higher price to credit cardholders cited cost recovery as

the main reason; those that did not cited concerns about negative reactions from

On the basis of these studies, the European Commission has recently decided not

to disallow Visa’s no discrimination rule at the European level, though it had

the following points are significant:

• the Commission considered that the no discrimination rule did restrict the

freedom of merchants to pass on a component of their costs to cardholders

and may be restrictive of competition;

132 See, for example, Australian Bankers’ Association (2001b) and Visa International (2001a).

133 Gans and King (2001b).

134 ITM Research (2000).

135 IMA Market Development AB (2000).

136 European Commission (2001a).

74

• however, the Commission is required under its powers to find that the restriction

on competition is “appreciable” before it may disallow the rule; and

• the Commission’s decision at the European level does not override the decisions

of domestic competition authorities. Hence, prohibitions on the no

discrimination rule in the United Kingdom, the Netherlands and Sweden stand.

The Reserve Bank’s payments system powers do not contain any materiality tests

comparable to the trigger of an “appreciable” restraint on competition applying

to the Commission. More importantly, the Reserve Bank is required to act in the

public interest to promote efficiency as well as competition.

A closer reading of the overseas evidence also suggests that merchant willingness

to charge differential prices might not have been accurately captured in the surveys.

Visa has claimed that, although the no discrimination rule has been prohibited in

credit card schemes in Sweden, bilateral agreements between acquirers and

merchants forbidding merchants from recovering credit card costs from cardholders

that price discrimination by merchants was uncommon, since the rule remains in

In the Netherlands, the study showed that almost three-quarters of merchants

surveyed were not aware that the no discrimination rule had been abolished, raising

the question of whether merchants thought they were still bound by that rule.

Looking at the two surveys together, a higher proportion of merchants impose a

fee for credit card use in the Netherlands, which has the higher average merchant

service fee, than in Sweden (Table 3.2). This illustrates a common-sense point that,

for many merchants, the cost and trouble of recovering credit card costs from

137 Visa International (2001a), p 36.

per cent

Sweden 2.0 6.5

Netherlands 4.5 19.0

Source: Based on a presentation by Alan Frankel to the Econometric Society of Australia, July 2001.

ITM Research (2000) and IMA Market Development AB (2000).

75

cardholders may not be worthwhile when merchant service fees are low but

becomes worthwhile when merchant service fees are higher.

In the Reserve Bank’s opinion, the argument that removal of scheme restrictions

on merchant pricing will have little impact on merchants is an argument, in

principle, against retaining these restrictions. In the absence of other public interest

considerations, the starting point for an assessment of private-sector regulations

imposed on merchants is that merchants should have the right – whether they use

it or not – to follow pricing strategies that promote the competitiveness of their

business. It may well be that supermarkets or other retailers with relatively small

transaction sizes will find the costs of systems changes and checkout queues too

high to justify a “fee for service” for credit cardholders. However, the fact that

discounting for cash is not uncommon for higher value items suggests that other

merchants – for example, those selling furniture, electrical equipment or other

high-value items – may want to recover their credit card costs. Utility companies,

schools or clubs that accept credit cards but clearly gain no additional revenues

might also choose to follow that pricing strategy.

Finally, some submissions have questioned whether permitting merchants to recover

their credit card costs would achieve anything that discounts for cash currently do

not. If that is the case, it is hard to understand why card schemes would object to

the removal of the restrictions. In principle, it should not matter whether merchants

recover their costs by charging above the cash price for credit cardholders or

charging below the credit card price for cash users. However, the two pricing

practices appear to be perceived quite differently. The “framing hypothesis” argues

labels “discount” and “surcharge” that are used by the credit card industry would

appear to be framed to suggest that the former is good and the latter is bad. It is

possible that discounts for cash have less impact on cardholders’ decisions to use

credit cards than facing a specific “fee for service” from merchants. In the United

States, the staunch defence of the no surcharge rule by American Express, while

allowing its merchants to offer cash discounts, would suggest that credit and charge

card schemes think that consumers might react differently to the different labels

and can be convinced that surcharges are unfair.

The third justification for scheme restrictions on merchant pricing relates to the

possible effects on consumers if these restrictions were removed. There are two

parts to the justification: consumers will be confused by facing differential pricing

138 Kitch (1990).

76

and/or merchants may exploit them. If the price a cardholder sees on the shelf

differs from that charged at the till, the cardholder may be confused and may lose

confidence in the credit card scheme. If individual merchants set different fees for

different cards, and the fees vary from one merchant to another, the argument is

In the Reserve Bank’s opinion, the argument about consumer confusion, which

has not been raised by consumer representatives, is easy to overstate. Consumers

have become increasingly accustomed to the unbundling and separate pricing of

goods and services, whether it be packaging or delivery charges, options on a new

motor vehicle or account services provided by financial institutions. Price variation

according to the type of payment instrument used is not unusual; consumers

understand that their choice of payment instrument can often provide leverage to

bargain on prices, as in the case of cash discounts for high-value goods. Consumers

also face other, albeit relatively inefficient, signals about the costs of payment

instruments in the form of minimum purchase obligations which some merchants

impose on customers who wish to use their credit cards; these minimum obligations

often differ between merchants and between cards issued by members of the four

party credit card schemes and by the three party schemes.

Over a decade ago, in reviewing the no discrimination rule in the United Kingdom,

the Monopolies and Mergers Commission reviewed concerns about consumer

confusion and concluded that such concerns were “… exaggerated because they

underestimate the ability of consumers, particularly of domestic consumers, who

Two pieces of evidence are cited in support of the argument about potential

merchant exploitation of consumers. The first is theatre bookings in the United

Kingdom, where credit card users are charged a fee on top of the ticket price for

bookings over the phone. The second is taxis in Australia, where customers paying

by credit card are charged a fee on top of the metered fare. Visa asserts that these

The Reserve Bank believes this evidence is unconvincing. Claims about theatre

bookings in the United Kingdom fail to distinguish between credit card bookings

and other bookings. Since credit cards are the only means of paying for tickets

over the phone, the fee could be either a charge for credit card use or for a phone

139 Australian Bankers’ Association (2001b), p 69.

140 Monopolies and Mergers Commission (1989), p 161.

141 Visa International (2001a), p 30, p 33 and pp 36-37.

77

booking. There is no evidence of a fee imposed on credit card use at the booking

Use of a credit card, charge card or debit card incurs a 10 per cent fee (plus GST)

over the metered fare; use of the taxi industry’s own payment system, Cabcharge,

which was the first non-cash payment method to be offered in taxis in Australia,

incurs a 10 per cent fee (including GST). The evidence does not indicate that credit

card users are being exploited but that the taxi industry is protecting its own

Cabcharge system from all other non-cash payment instruments.

A variant on the exploitation argument is that merchants will discriminate against

wealthier customers by charging them more to use a credit card. The notion is

that credit cardholders are typically wealthier than non-cardholders; if so, merchants

might interpret a customer’s desire to use a card as evidence of willingness to pay

This argument also does not stand up to scrutiny. In principle, it seems unlikely

that such behaviour could be anything but a once-off effect – cardholders would

not frequent such a merchant once its pricing behaviour became known. Customers

could also easily avoid the merchant’s attempt to discriminate by paying by other

means. More importantly, however, such pricing behaviour would likely be in breach

and misleading statements about the prices of goods and services. The ACCC has

advised the Reserve Bank that charging a “fee for service” for credit card use is not

existence and amount of the fee prior to a transaction being entered into. If a

merchant were to add a fee for accepting a credit card, it would need to post that

fee for all customers to see. The ACCC notes that this situation is not analogous to

GST pricing where the GST component must be included in the price. Unlike the

GST component, any fee charged by a merchant for accepting a credit card is not

an integral part of the total price of a good; a consumer could choose to avoid

142 In a subsequent submission, Visa has conceded that it cannot demonstrate that the booking

fee is a fee for credit card usage. Visa International (2001e).

143 Gans and King (2001d), p 49.

144 The ABA has argued that the ACCC stance on GST pricing – that the GST component must be

included in the price - implies that a “fee for service” for credit card use would need to

follow the same principle. See Australian Bankers’ Association (2001b), p 69.

78

In the Reserve Bank’s opinion, restrictions imposed by credit card schemes on the

freedom of merchants to set their own prices are not in the public interest. These

restrictions harm consumers who do not use credit cards because they pay higher

prices for goods and services than they would otherwise. By distorting the relative

prices of payment instruments, the restrictions are not conducive to efficiency in

the payments system. In addition, the restrictions undermine the competitive

pressure which merchants might impose on interchange fees and merchant service

The justifications for the restrictions do not, in the Reserve Bank’s opinion, outweigh

these consequences. Overseas evidence provides no support for assertions that credit

card networks suffer a significant loss of network benefits where such restrictions

are removed. If overseas experience is a guide, the removal of scheme restrictions

may not have a large impact on the pricing strategies of merchants; many merchants

may judge that it is not worth their while to charge a fee for accepting credit

differential prices for different payment instruments, particularly given that credit

card issuers themselves are able to achieve that outcome through the use of loyalty

programs (which reduce the net price of goods and services for credit cardholders).

For these reasons, the Reserve Bank has concluded that a standard on merchant

pricing is needed, in the public interest, to promote efficiency and competition in

the payments system. The standard would apply to participants in the three

The Reserve Bank’s draft standard will ensure that a merchant accepting a credit

card of a designated credit card scheme is free to recover from the cardholder the

cost of accepting that card. The draft standard has two key provisions. First, it

prohibits designated credit card schemes from having any rules in Australia that

restrict merchants, if they so wish, from charging a “fee for service” for accepting

a rule in Australia requiring that credit card acquirers, in their contractual

agreements with merchants, must allow merchants the freedom to recover their

credit card costs. The draft standard also requires that merchants be advised by

145 Gans and King note that “[t]he ability to cross-subsidise makes merchants more willing to

bear higher merchant service charges as they derive an indirect benefit from this

cross-subsidy.” Gans and King (2001a), p 107.

79

their acquirers, or by the credit card schemes, that they have the freedom to recover

their credit card costs.

The draft standard would not preclude contractual agreements between a credit

card acquirer and a merchant that would limit the size of the “fee for service” for

accepting credit cards to the cost of a merchant of accepting a credit card. Such

agreements are permitted in the United Kingdom notwithstanding the prohibition

The Reserve Bank will consult the three party card schemes, American Express and

Diners Club, on why the standard on merchant pricing should not apply to them.

Access Economics, consultants to American Express, has argued that American

Express should be free to continue to impose restrictions on merchant pricing. Its

argument is that the no surcharge rule in four party schemes allows their members

to “exploit” the market power of these schemes through interchange fees, but

that American Express has neither market power nor interchange fees. However,

restrictions on merchants recovering from their customers the costs of accepting

American Express cards have, in principle, the same types of effects on the prices

of goods and services and on price signals to users of payment instruments as do

those imposed by MasterCard and Visa.

80

2. This Standard applies to the three credit card systems designated on

12 April 2001 by the Reserve Bank of Australia under Section 11 of the

(i) the credit card system operated within Australia known as the

Bankcard Scheme;

(ii) the credit card system operated within Australia known as the

MasterCard System or MasterCard Network Card System; and

(iii) the credit card system operated within Australia known as the Visa

System or the Visa Network Card System,

each referred to as follows as a Scheme.

3. This Standard applies to any rules of a Scheme that affect the rights and

entitlements of a merchant to recover from a credit cardholder the cost

of accepting a credit card issued by any of the participants in a Scheme.

4. In this Standard:

an “acquirer” provides services to merchants to allow the merchant to

accept a Scheme’s credit cards;

81

“rules of a Scheme” or “rules” include the constitution of a Scheme, rules,

by-laws, procedures or any arrangement in relation to a Scheme by which

participants in the Scheme in Australia may consider themselves bound;

a “Scheme Administrator” is the administrator of the Scheme, if any;

a “Scheme’s credit card” is a credit card issued in accordance with the

rules of that Scheme.

5. This Standard is to be interpreted:

• in accordance with its objective; and

• by looking beyond form to substance.

6. This Standard comes into force on [ ].

7. The rules of a Scheme must not include any rule that requires a participant

in the Scheme to prohibit, or that has the effect of prohibiting, a merchant

in Australia from recovering from a credit cardholder the cost to the

merchant of accepting a credit card issued by a participant in the Scheme.

8. The rules of a Scheme must include a rule that prohibits acquirers in the

Scheme from imposing any term or condition in a contract, arrangement

or understanding with a merchant in Australia which prevents, or has the

effect of preventing, a merchant from recovering from a credit cardholder

the cost to the merchant of accepting a credit card issued by a participant

in the Scheme.

9. A participant in a Scheme must not prevent a merchant in Australia from

recovering from a credit cardholder the cost to the merchant of accepting

a credit card issued by a participant in the Scheme.

10. The Scheme Administrator or, if none, each acquirer in the Scheme must

ensure that each merchant in Australia that accepts a credit card issued by

a participant in the Scheme is advised in writing of the provisions of this

Standard.

82

11. The Scheme Administrator or, if none, each of the participants in the

Scheme must notify the Reserve Bank of Australia of the changes made to

the rules of the Scheme to give effect to this Standard.

Reserve Bank of Australia

SYDNEY

83

The Bankcard, MasterCard and Visa credit card schemes have regulations and

policies, agreed to by their respective Australian members, that restrict entry to

the schemes. Broadly speaking, the regulations:

• limit the types of institutions eligible to become members of the schemes as

credit card issuers and acquirers; and

• restrict the range and scale of activities that card scheme members may

undertake.

As noted in Chapter 1, the Financial System Inquiry identified restrictions on

participation in credit card schemes as an area of policy concern. Specifically, card

scheme rules might be used to restrict the ability of non-deposit-taking institutions

to compete in new payment technologies. The Inquiry therefore recommended

that the ACCC maintain a watching brief over credit card rules and membership

arrangements.

anti-competitive, and against the public interest. Such restrictions inhibit normal

market processes, under which resources are free to enter a market in response to

profit opportunities; in doing so, or threatening to do so, new entrants drive profits

down to “normal” rates. The Joint Study acknowledged that there are good reasons

why credit card issuers and acquirers need to have the relevant skills and financial

standing. However, it was not convinced that the card scheme restrictions on entry

had struck a balance between competition and the control of risks that was in the

public interest. The credit card schemes and their members, nonetheless, defend

these restrictions as being essential to the safety of the schemes or, in the case of

restrictions on members’ activities, to the “balanced development” of the schemes.

This Chapter considers whether the restrictions imposed by the designated credit

card schemes on eligibility for membership, and on members’ activities, are in

the public interest. Firstly, it reviews the extent of competition within the credit

card market in Australia. It then analyses the nature of the risks which credit card

issuers and acquirers bring to card schemes, and assesses how the regulations and

policies of each of the schemes address these risks. On the basis of this review, the

Reserve Bank judges that there is scope for a more liberal regime of access to the

credit card schemes that will promote competition and efficiency without

compromising their safety. A draft access regime with that objective, which allows

for the entry of specialist credit card service providers supervised by APRA, is

discussed in the concluding section.

84

Credit card issuing and acquiring are currently very profitable activities in Australia.

Information provided to the Joint Study by card scheme members showed that the

provision of credit card services generates revenues well above average costs,

especially for financial institutions which are both significant card issuers and

acquirers. The margins are particularly wide in credit card acquiring (Table 4.1).

Although card scheme members were generally unable to supply suitable capital

data, indicative figuring by the Reserve Bank – based on the main risks against

which capital would be held – suggested that the margins in credit card issuing

and acquiring were well above what would be required to provide a competitive

rate of return on capital.

costs and revenues per transaction

$, 1999

Revenues 2.69 Revenues 1.78

Direct costs 0.43

Interchange paid 1.06

Direct costs 1.93 Costs 1.49

Margin 0.76 Margin 0.29

(mark-up over direct costs) (39.4%) (mark-up over direct costs) (67.4%)

Costs of loyalty programs 0.46

Source: Reserve Bank of Australia and Australian Competition and Consumer Commission (2000),

p 45.

147 This degree of concentration also contrasts sharply with the United States, where in 1997 the

four largest credit and charge card issuers accounted for between 31 and 42 per cent of the

market, depending on the measure used. See Evans and Schmalensee (1999), p 226.

The strong profitability of credit card activities can be seen against the highly

concentrated nature of the credit card market in Australia. The four major banks

dominate both credit card issuing and acquiring. As issuers, they account for around

87 per cent of transactions undertaken on bank-issued cards, a higher level of

85

other deposit-taking institutions, including building societies and credit unions,

issue credit cards, but have only a very small market share. The acquiring market is

even more concentrated, with the four major banks accounting for 91 per cent of

credit card transactions acquired by banks and the next four banks for the remainder.

Though open to new entry by financial institutions, the credit card market is,

broadly speaking, closed to the participation of non-financial institutions in their

own right. As the Joint Study noted, a concentrated market can still be competitive

if entry barriers are low but where these barriers are high, the market power of

incumbents is likely to be entrenched.

per cent of number of transactions, 2000

Four major banks 87 91

Next four banks 10 9

Source: Reserve Bank Transaction Cards Statistical Collection.

148 Australian Bankers’ Association (2001b), pp 30-33.

149 Prices Surveillance Authority (1992) and (1994), p 27.

Although not challenging the data used, the ABA has submitted that margins for

suggested, first, that these margins should not be considered separately but jointly,

because of the network character of credit card businesses. While a joint measure

might be relevant for three party card schemes, which generally have a sole issuer

and acquirer, it is not an appropriate suggestion in the case of four party card

schemes, the main strength of which – according to proponents of existing

arrangements – is the separate and competing interests of credit card issuers and

acquirers. The suggestion is also out of line with the business models under which

card scheme members in Australia manage and seek to allocate capital to issuing

and acquiring as separate activities, and with the assessment of credit card

Secondly, the ABA has argued that the Joint Study’s findings used only one year of

data (1999) and did not take into account losses incurred in the early years of

operation of the credit card schemes. Elsewhere, however, the ABA has conceded

86

that such losses have not been recorded in the formal financial records of banks

banks did provide detailed data on credit card profitability to earlier reviews

conducted by the Prices Surveillance Authority, which showed that credit card

acknowledges that losses were incurred in establishing credit card schemes in

Australia, but believes it is quite valid to get a reading on current levels of

profitability, given that the credit card is now a well-established product and familiar to consumers.

Thirdly, the ABA has argued that the Joint Study erred in not including loyalty

programs in the costs of credit card issuing. The Reserve Bank acknowledges that

expenditure on loyalty programs affects issuers’ accounting profits. In an economic

sense, however, loyalty programs represent a rebate to certain groups of credit

cardholders at the discretion of some, though not all, card issuers; they affect the

price at which credit card services are provided to cardholders but are not a cost

that is integral to the provision of these services. This matter was discussed in

Chapter 2. Against the background of continuing high gross margins in credit card

issuing, competition in this area over recent years has taken the particular form of

Concerns that competition is not working as it should in Australia are particularly

strong in the case of credit card acquiring. The ARA has provided data on the

merchant service fees paid by merchants, according to annual turnover (Table 4.3).

Smaller merchants can pay merchant service fees as high as four per cent per

transaction. After paying interchange fees to issuers, the amount retained by

acquirers for providing services to merchants averages around one per cent per

transaction, and can be as high as three per cent in the case of smaller merchants.

Evidence on the degree of competition in credit card acquiring – apart from the

wide margins being earned – comes from a cross-country comparison of the share

of merchant service fees which is retained by acquirers, after payment of

interchange fees to card issuers. Credit card acquiring is essentially a volume-based

processing business which is subject to significant economies of scale; in major

countries, strong competition and improvements in technology have driven the

fees retained by acquirers down towards the floor set by interchange fees. In the

United States, acquirers retain about 20 per cent of the merchant service fee and

150 Australian Bankers’ Association (2001e), p 11.

151 See, for example, Prices Surveillance Authority (1994), p 28.

152 Gizycki and Lowe (2000), p 195.

87

Australia, on average, retain almost 50 per cent of the merchant service fee.

Other evidence about the degree of competition in acquiring comes from the

structure of merchant service fees in Australia. With only one exception of which

the Reserve Bank is aware, these fees – which cover the interchange fee and

is essentially volume-based, a flat fee for acquiring services would be more in line

the structure of merchant service fees ensures that revenues from credit card

acquiring continue to rise with the total value of credit card transactions, without

regard to acquiring costs. This fee structure might benefit merchants with a

preponderance of small-value transactions, but merchants with high-value

transactions can be paying much more in merchant service fees than the costs to

acquirers of providing the service.

per cent, 2000

0.10 2.53 1.36 4.00

0.25 2.30 1.25 4.00

0.50 2.10 0.90 4.00

1.00 1.75 1.00 4.00

2.50 1.68 1.00 3.00

5.00 1.53 1.19 3.25

10.00 1.51 0.90 3.00

25.00 1.47 1.00 3.00

50.00 1.38 1.25 1.50

100.00 1.35 1.25 3.00

500.00 1.30 1.00 3.00

Source: Australian Retailers Association (2001a), p 14.

153 MasterCard International (2001) p 8, European Commission (2000) and British Retail

Consortium (1999).

88

In its earlier reviews of credit card pricing, the Prices Surveillance Authority

of pricing as they do not seem to be related to costs. The Joint Study noted that

competitive pressures have not led to a more appropriate two-part charging

structure for merchants. If the acquiring market were strongly competitive,

merchants should expect to be offered fee structures that were more closely aligned

with acquirers’ costs.

One major utility has advised the Reserve Bank that, despite explicit requests for

alternative fee arrangements, no bank tendering for its credit card business was

of its survey, the Australian Retailers Association noted that:

“… smaller retailers with lower turnover have a lesser ability to

negotiate lower MSFs. However the results of the survey did indicate

that a few retailers with high turnover still paid high MSFs. This may

be the result of a lack of knowledge on the part of the retailer, or a

Both interpretations are consistent with less-than-vigorous competition for

merchants’ business by acquirers.

In a confidential submission, the ABA has provided data showing a trend decline

in average merchant service fees in Australia from 1995 to 2000 to support its

claim that acquiring is a highly competitive activity. An earlier submission published

by the ABA showed a smaller fall in merchant service fees over much the same

period, which matched the fall in average interchange fees as credit card transactions

both revenues and costs. On the revenue side, the relevant variable is revenues per

transaction, which depend not only on the merchant service fees but also on the

average value of credit card transactions to which the fees are applied. Over the

period 1995 to 2000, the average value of credit card transactions rose by almost

20 per cent, meaning that acquirers’ revenue per transaction fell only slightly despite

the claimed strong decline in merchant service fees. And over the same period,

acquirers’ costs per transaction would have benefited from substantial reductions

in processing and telecommunications costs and from economies of scale through

higher transaction volumes.

154 Australian Retailers Association (2001a), p 10.

155 Frontier Economics (2001), p 33.

89

In the Reserve Bank’s view, claims that the credit card market in Australia is highly

competitive are an echo of claims made in the early 1990s that the market for

residential mortgages was competitive, even with spreads between the standard

mortgage rate and the cash rate of over four percentage points. It took the entry of

specialist mortgage originators to transform that market, driving spreads to below

two percentage points within a few years. A recent review of competition and

profitability in the Australian financial system concluded:

“[a]n important lesson from the 1990s is that the competitive

pressures needed to drive margins lower are more likely to come from

new entrants, rather than from firms with large existing market shares.

The lesson becomes even more relevant in the current environment

A credible threat of entry by non-traditional participants is needed before it could

be claimed that the credit card market in Australia is fully competitive and generates

only normal profits. For this reason, the public interest requires that restrictions

the schemes from any risks introduced by their members.

Credit card issuers and acquirers perform a range of functions in credit card

schemes, which expose them to financial risks. If not prudently managed, these

risks can create exposures for other scheme members.

cardholders; authorise cardholders’ transactions; settle with acquirers for

transactions accepted by merchants; collect payments from cardholders; deal with

disputed and fraudulent transactions; and contribute as necessary to the scheme’s

loss-sharing arrangements. As a consequence, issuers face both liquidity and credit

risks.

Liquidity risks arise because issuers must settle with acquirers within a day or so

of transactions taking place, while repayments by cardholders will be spread out

over many days or months. Credit risks arise because cardholders may fail to pay

their outstanding credit card accounts. Issuers must be able to manage both of

these risks if they are to settle their obligations to acquirers; their ability to assess

the creditworthiness of cardholders is critical. For this reason, the Joint Study

156 Gizycki and Lowe (2000), p 198.

90

reinforced by the schemes’ “honour all cards” rules, which require that all cards

issued by members of a scheme are honoured by merchants regardless of the

identity of the issuer. Under formal loss-sharing rules in credit card schemes, the

failure of an issuer to manage its risks creates obligations on other scheme

• fails to settle its obligations to acquirers in full; or

• fails to meet loss-sharing obligations in the event that another member is unable

to meet its settlement obligations. Hence, each scheme member, even if it only

issues cards, has an interest in ensuring that all issuers can meet their settlement

obligations.

Risks to issuers need to be kept in perspective. While their settlement obligations

have to be met daily, their demand for liquidity should be reasonably predictable,

given normal seasonal spending patterns and established billing cycles. For credit

card issuers, there is no obvious counterpart to a run on liquidity where depositors

have concerns about the soundness of a financial institution; cardholders are most

unlikely to run up new debts suddenly if the solvency of their credit card issuer

were in doubt.

and services paid for by credit cards, and sign them up to accept the scheme’s

credit cards; capture merchants’ credit card transactions and seek their authorisation

from issuers; guarantee payment to merchants for the value of credit card

disputed and “charged back” transactions (see below); and contribute as necessary

to the scheme’s loss-sharing arrangements. Acquirers also face both liquidity and

credit risks, though of a different dimension to issuers.

In the normal course, acquirers are net receivers of funds from issuers at daily

settlement. Because there is often a delay of a day or so between their payments to

merchants and receipt of settlement funds from issuers, acquirers may face liquidity

risks, although these should be readily manageable. Acquirers may also face liquidity

and credit risks arising out of the rules of Bankcard, MasterCard and Visa providing

for refunds to credit cardholders.

157 Reserve Bank of Australia and Australian Competition and Consumer Commission (2000),

p 56.

158 See MasterCard International (2001), Allen Consulting Group (2001), p 3, p 12.

159 Provided required checks have been undertaken.

91

Most credit card transactions do not generate refund obligations for acquirers. Take

for example a restaurant meal or groceries paid for by credit card. The meal has

been consumed or the groceries purchased, the card is present and the merchant

has a record of the cardholder’s signature. The transaction has been completed on

a “delivery-vs-payment” basis and the scope for the customer to initiate a refund

to its credit card account (known as a “chargeback”) is virtually nil. However,

when goods and services are delivered after payment – such as airline tickets,

package holidays, mail order, telephone or Internet purchases – there is a risk that

delivery might not be carried out or that a cardholder might dispute the transaction.

In such cases, the card scheme rules provide for a refund to the cardholder. The

issuer credits the cardholder’s account and seeks reimbursement from the acquirer;

the acquirer, in turn, must recover the funds from the merchant. For an acquirer

with a diversified base of sound merchants, this process would normally pose

only minor liquidity risks. However, the acquirer does face a credit risk that a

merchant cannot pay or is fraudulent; under the card scheme rules, the acquirer

who has signed that merchant up to the scheme must bear the loss. Hence, acquirers

also need to have financial substance commensurate with the particular risks they

bear.

Under the formal loss-sharing rules, an acquirer can create exposures for other

scheme members if it:

• fails to make up any shortfall in reimbursement to issuers for “chargeback”

transactions; or

• fails to meet loss-sharing obligations in the event that another member cannot

meet its settlement obligations. As with issuing, therefore, each scheme member

has an interest in ensuring that acquirers can assess, price and bear the risks

associated with credit card transactions at the merchants they sign up.

As a means of containing risks in credit card issuing and acquiring, each of the

designated credit card schemes imposes restrictions which:

• limit the types of institutions that are eligible for membership; and

• in the two international schemes, prevent members of the schemes from

acquiring their own transactions (“self acquiring”).

92

The decision-making structures of the designated credit card schemes are important

to the way in which restrictions on eligibility for membership operate, how they

can be changed and where decision-making power lies.

MasterCard and Visa are international schemes with various levels of

decision-making and responsibility. Although details and nomenclature vary, both

schemes operate at three key levels. First, there is an international board for each

scheme which has ultimate decision-making power. One Australian member is

currently represented on the international board of MasterCard. Below that is a

regional board; in both schemes Australia is included in groupings of countries in

the Asia-Pacific region. Australian banks are currently represented by two members

on the 23 member Asia-Pacific Board of MasterCard and by three members on the

27 member Asia-Pacific Board of Visa. Finally, each scheme has an Australian

executive committee, the details of which were provided in Chapter 2. Each of the

schemes’ decision-making bodies has a range of delegated responsibilities and

powers.

Bankcard’s structure is less complex. Bankcard is an association directly controlled

in all respects by its members, which are all Australian banks. Other than

requirements imposed under Australian law, there are no constraints on the ability

of the members to change scheme rules.

MasterCard has provided copies of its Bylaws to the Reserve Bank but does not

wish to have them quoted publicly. However, its membership requirements have

been described in its public submissions to the Reserve Bank:

“The main rule concerning eligibility for membership of MasterCard

provides that, in order for a corporation or organisation to be eligible

to become a member of MasterCard, it must be ‘a financial institution

that is authorised to engage in financial transactions under the laws

MasterCard also requires that “… such a financial institution must be regulated

160 MasterCard International (2001), p 27.

93

MasterCard’s rules build in a degree of flexibility. Its requirement that members

conduct financial transactions rather than being authorised deposit-taking

institutions means that “there are card companies in Asia which are members who

Being a regulated or supervised financial institution in Australia is not, in itself, a

sufficient condition to gain membership of MasterCard. An application for

membership is decided by a majority vote of international directors or regional

directors present, depending on which meeting considers the membership

application. In Australia, new members pay an entry fee.

The Bylaws of Visa International require that applicants for membership be:

“Organized under the commercial banking laws or their equivalent

of any country or subdivision thereof, and authorized to accept demand deposits; or

…

An organization (i) whose membership the Board of Directors deems

necessary to penetrate a given country in which no Principal has

jurisdiction, or (ii) that the Principals with jurisdiction in a given

Being an authorised deposit-taking institution (ADI) in Australia does not guarantee

membership of the Visa scheme. Eligible applicants must also submit a business

plan and satisfy Visa International that they have appropriate operational capacity

and will “contribute to the overall operation and growth of the Visa payments

system.” Applicants must also meet the requirements of Visa International’s Global

Member Risk Policy; Visa has advised the Reserve Bank that “assessment often results

An application for membership must be endorsed by a majority vote of directors

present at the Asia-Pacific board meeting, where the application would be

considered. In Australia, new members pay an entry fee.

163 Visa International By-laws, Membership Section 2.01.

164 Visa International (2001c), pp 10-12.

94

Prior to the Joint Study, membership requirements for Bankcard were characterised

by their lack of transparency and objectivity. Membership applications were

had refused membership to a number of banks, including Citibank, whose parent

company was at the time the largest issuer of bank credit cards in the world; it

also imposed a formula-based membership fee which in recent years amounted

to around $1 million. The Joint Study concluded that Bankcard’s membership

procedures appeared to have operated to ensure that the field of competition for

the issuing of Bankcard and the acquiring of Bankcard transactions remained tightly

restricted to a small number of banks.

Bankcard has subsequently undertaken a major review of its membership

requirements, which has resulted in a significant liberalisation of access to

Bankcard if it is:

• “an authorised deposit-taking institution (ADI) in Australia supervised by the

Australian Prudential Regulation Authority (APRA); or

• a financial institution supervised by an official prudential regulator in another

country that is recognised by APRA; or

• an entity whose liabilities in respect of the Bankcard Scheme are guaranteed by

an APRA supervised organization (or an organization supervised by a foreign

prudential regulator recognised by APRA) under a guarantee that survive[s]

Bankcard considered allowing unsupervised entities seeking membership to lodge

collateral as an alternative to having a guarantee, but concluded that it was

“unworkable in key respects in relation to the objectives of safety and stability

Bankcard now has a single-tiered voting structure based on turnover. Applications

for membership are decided by a two-thirds majority of directors and new members

no longer need to submit a business plan. The entry fee has been reduced to a flat

165 Australia and New Zealand Banking Group, Commonwealth Bank, National Australia Bank,

Westpac Banking Corporation.

166 Bankcard (2001a) and (2001b).

167 Australian Bankers’ Association (2001b), p 63.

95

fee of $66 000 (inclusive of GST), which is stated to be comparable with entry

Summing up the common features of membership restrictions, the principal route

to scheme membership in each of the designated credit card schemes is being a

deposit-taking institution authorised and supervised by APRA (or under a similar

regime overseas). Indeed, all members of the three schemes in Australia have joined

through this route. Being an ADI, however, is only a condition for eligibility, not

for membership as such. Although the detail varies, all three schemes require

assessment and endorsement of any application for new membership by current

members. At the same time, all three schemes provide some degree of flexibility.

MasterCard allows institutions which “engage in financial transactions” to be

members provided they are supervised; it also allows non-traditional members if

this is necessary to conform with local laws, or for any reason. Visa allows non-ADIs

to be members if local members unanimously agree. As discussed below,

the international schemes have taken advantage of this flexibility to admit

non-traditional members in other countries, but not Australia. Bankcard’s new rules

allow a non-ADI with a guarantee from an ADI to become a member.

Membership restrictions are defended by the credit card schemes and their members

on the basis that they provide assurance about the financial substance of participants

in the schemes. On the issuing side, submissions have emphasised that the “honour

all cards” rule – under which the merchant is guaranteed payment even if the

issuer fails to settle its obligations – places a burden on all members to ensure the

that acquiring involves more than the provision of network and processing facilities

and is “at core” a banking function, focused on managing the risks of merchant

for Compass Airlines, was required under the schemes’ rules to make good losses

incurred by cardholders when Compass could not honour tickets which had been

members can face losses because of chargebacks and merchant failure, and that in

the United States it has been required to set aside funds as a buffer against such

losses.

169 Australian Bankers’ Association (2001b), p 40.

170 See MasterCard International (2001), Allen Consulting Group (2001), p 3, p 11 and p 18.

171 Australian Bankers’ Association (2001b), p 59.

172 More recently, banks which have acquired transactions for Ansett tickets have had to bear

losses when tickets were not honoured.

96

At the same time, submissions have claimed that it is not in the interest of the card

schemes to restrict membership, since growing membership will attract larger card

bases and a wider range of merchants which, in turn, benefits existing members

The Joint Study acknowledged that “… the requirement of authorisation [as deposit

takers] and ongoing prudential supervision has been a long-established and effective

whether current membership restrictions limit competition more than is necessary

to ensure the safety and stability of the credit card schemes.

The current membership restrictions have two separate elements – a restriction

on the basis of institutional status (broadly speaking, members must be deposittaking

institutions) and a restriction on the basis of regulatory status (members

must be authorised and prudentially supervised). In the Reserve Bank’s view, any

requirement that a credit card issuer or acquirer must be a deposit-taking institution

is, on its own, very difficult to defend. Deposit-taking institutions undertake a

wide range of financial activities, of which the provision of payment services may

be only a small part, and have a commensurate range of skills and infrastructure.

Their capital requirements are determined by the often complex risks that arise.

They also pursue comprehensive risk management policies designed to ensure,

fundamentally, that depositors can be confident of withdrawing their funds in full

on demand. Credit card issuing and acquiring are more specialised activities and

generate risks, as discussed above, that are much narrower and easier to monitor

and control than those across the spectrum of activities of a deposit-taking

institution. The risks of merchant default for an acquirer, for example, argue for a

diversified merchant base and adequate capital for acquirers that sign up large

merchants providing delayed delivery of goods and services; it does not argue that

acquirers should be deposit-taking institutions.

Most submissions have focused not on the issue of institutional status but on the

requirement that, in general, members must be prudentially supervised. The

arguments are not that the full range of prudential standards for an ADI are required

to address the specific risks in credit card activities; rather, the arguments are about

convenience, cost and discretion. They take the form that:

• authorisation and ongoing prudential supervision by APRA is an efficient and

non-discriminatory screening device; and

173 See Frontier Economics (2001), p 43 and Australia and New Zealand Banking Group

(2001b), p 7.

174 Reserve Bank of Australia and Australian Competition and Consumer Commission (2000),

p 56.

97

• in any event, the restrictions are not “economic” restrictions that lessen

competition because non-ADIs can effectively participate in issuing and

The main thrust of this argument is that reliance on APRA’s prudential assessment

of ADIs avoids the need for card schemes to undertake their own assessments,

prudential standards for ADIs around the world, where its scheme has more than

the same detailed assessments, their costs would rise. Reliance on APRA’s prudential

assessment is also argued to be objective and reduces the risk that the schemes

will in some way apply variable standards or that a scheme’s existing members

The Reserve Bank acknowledges that there is some merit in using APRA’s prudential

oversight as a screening device. In practice, however, it has not eliminated the

involvement of scheme members in assessing membership applications. Being an

ADI does not entitle an institution to scheme membership; it is only the first hurdle

and prospective members must pass further tests where the discretion and

judgments of existing members come into play. Visa, for instance, subjects all

prospective members to its Global Member Risk Policy and, in some cases, requires

MasterCard have also been prepared to admit non-ADIs in a number of Asian

countries. In Japan, Korea, Hong Kong, Indonesia and Malaysia, a special licence

scheme allows entities which are not all prudentially regulated, such as consumer

credit companies and retailers, to issue cards; in the case of Visa, members in those

countries have accepted that this is the best way to penetrate new merchant sectors

and the Asia-Pacific Board has agreed. Inevitably, then, the schemes and their

members are involved in making credit assessments of prospective members.

175 Visa International (2001a), MasterCard International (2001), Australia and New Zealand

Banking Group (2001b) and Allen Consulting Group (2001).

176 Australian Bankers’ Association (2001b), p 8, Visa International (2001a), pp 44-45,

MasterCard International (2001), pp 28-29 and Allen Consulting Group (2001), p 12.

177 MasterCard International (2001), p 28.

178 Visa International (2001a), p 44.

179 This contrasts with Bankcard’s conclusion that it would be unworkable for its scheme to

accept collateral as a way of guaranteeing members’ obligations.

98

This involvement of scheme members highlights an underlying tension in credit

card scheme arrangements that can reinforce any anti-competitive impact. While

it may well be in the interests of a scheme to admit new members and expand the

network, it may not be in the interests of some existing members whose own

issuing or acquiring business may be threatened. Before its recent rule changes,

Bankcard’s restrictive approach to membership was a clear illustration of this

tension.

Bankcard has now, however, accepted that ADI status need not be the minimum

entry requirement for credit card schemes in Australia. Non-supervised institutions

may become members of Bankcard, provided they have a guarantee of their credit

card obligations from an ADI. These new arrangements, though yet to be tested,

may go some way to liberalising access to membership of Bankcard, because there

is a reasonably long list of ADIs which are not in this scheme and may be prepared

to offer such guarantees. Nonetheless, the guarantee would add an explicit cost to

the credit card operations of a non-ADI which would reduce its competitive impact.

Moreover, the use of guarantees is unlikely to be a practical solution for liberalising

access to the international card schemes in Australia. Non-ADIs may find it very

difficult to secure a credible guarantor that was not already a member of MasterCard

and Visa.

In any event, several submissions have questioned whether the Australian members

of the international card schemes could achieve any changes to the membership

a very small proportion of the Visa and MasterCard membership of more than

20 000 institutions, and argue that the international schemes would be reluctant

to countenance changes that might be workable in Australia but would set

“undesirable precedents” if they were to be applied elsewhere. On the other hand,

the schemes’ rules do contain flexibility which would allow Australian members,

if they so wished, to admit or recommend the admission of non-ADIs to scheme

membership in Australia.

the argument is that co-branding provides organisations that are not scheme

180 See Australian Bankers’ Association (2001b), Australia and New Zealand Banking Group

(2001b), Allen Consulting Group (2001).

181 See Australian Bankers’ Association (2001a) and (2001b), Allen Consulting Group (2001),

Australia and New Zealand Banking Group (2001b) and MasterCard International (2001).

99

members with a form of “economic participation” in credit card issuing equivalent

to that provided by actual membership. The ABA, for example, argues that:

“In Australia, not only large corporates such as Telstra and Qantas,

but also organisations of considerably smaller scale (such as sporting

organisations) have been able to conclude apparently satisfactory

agreements effectively (in economic terms), giving them participation

On the acquiring side, it is argued that third-party processors, network operators

or transactions switches can undertake operational roles which are outsourced to

them by acquirers who are scheme members. The acquirers retain the financial

obligations while reducing costs and providing business opportunities to their

outsourcing partners.

The Reserve Bank accepts that co-branding may provide non-members with a

degree of economic participation, but this is not equivalent to membership.

Co-branders do not have the same rights to participate in scheme governance and

strategy as members. They have no role in setting scheme rules or interchange

fees. Importantly, they do not have the same relationship with cardholders as scheme

members that issue cards and extend credit; in particular, they do not have access

to data on customers’ spending patterns. They have to share revenues with members,

even if they provide the bulk of the distribution network. In short, scheme members

can extract an “economic rent” from co-branders because they have access to a

scarce commodity not available to the co-brander – viz, scheme membership.

The same arguments apply to the outsourcing of acquiring functions. The scheme

members remain the formal acquirers and earn the merchant service fee, part of

which is passed to outsourcing partners. These partners, however, have no input

into scheme governance, rule-setting or strategy, even if they perform most of the

work and have substantial investment in infrastructure. Again, this may result in

an “economic rent” to the scheme member.

In the Reserve Bank’s opinion, the submissions have not advanced a convincing

reason why a number of the organisations cited as examples of successful

co-branding – organisations with a good credit rating, an extensive distribution

network and a long history in credit assessment, billing and debtor management

– lack the financial substance to be credit card issuers in their own right. Similarly,

the submissions have not explained why institutions that understand the acquiring

business and have the substance to deal with the associated risks need to be ADIs.

182 Australian Bankers’ Association (2001b), p 58.

100

To sum up, the Reserve Bank is not persuaded by the arguments that credit card

issuers and acquirers must be deposit-taking institutions, authorised and supervised

by APRA, to be able to manage the risks involved in credit card activities. It

acknowledges that reliance on APRA’s prudential assessments does lend some

objectivity to membership procedures and defrays scheme costs but, under the

schemes’ rules, it provides no guarantee of membership. However, in the Reserve

Bank’s opinion, the requirement that members must be deposit-taking institutions

makes the barriers to entry more restrictive than the minimum necessary for the

type and scale of risks involved. As discussed below, alternative membership

regulations can be devised that provide, in the public interest, a more appropriate

balance between the promotion of competition and efficiency, on the one hand,

and the control of card scheme risks on the other.

Restrictions on eligibility for membership are the main means by which the

designated credit card schemes seek to contain risks. As part of their risk control

framework, the international schemes also have policies (rather than formal rules)

that prohibit members of the schemes from acquiring their own transactions.

Policies against self-acquisition are largely redundant when card scheme

membership, and the provision of acquiring services to merchants, are restricted

to ADIs. However, these policies could take on importance if non-traditional

participants were admitted to credit card schemes. An example would be a telephone

company that issued a scheme’s credit cards in its own right and had an acquiring

capacity. A policy against self-acquisition would prohibit that company from

acquiring the credit card transactions made by customers to settle their telephone

accounts; those transactions would have to be acquired by another scheme member

(presumably an ADI).

MasterCard has stated that its policy against self-acquisition is quite flexible:

“If there were to be some minor amount of self-acquisition by an

acquirer, this would not of itself cause MasterCard undue concern.

For example, if some incidental goods or services offered by a member

were paid for by credit card. There is more concern if an acquirer

were proposing to self-acquire a substantial volume of transactions.

The policy has not been the subject of application in Australia to date

as there has not been any occasion when a member has sought to

acquire a significant volume of its own transactions. The policy has

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been applied in the U.S. where there are instances of merchants owning

The ABA says that:

“Within the Visa system there are understood to be a number of rules

which impact upon the issue of self acquisition, including some of

It is understood that the impact of such rules can only be assessed in

the context of specified factual situations and that with respect to

Visa the issue of a self acquisition policy has not arisen for concrete

Visa argues that the question simply does not arise under its rules:

“A merchant as a merchant cannot acquire its own transactions. It

would be feasible, however, for an acquirer to sign up only one

merchant – that is, the merchant that is part of the same group of

companies as the acquirer … however, Visa does not allow a member

to be an acquirer only …

Having satisfied those requirements, Visa has not to date encountered

[in the Asia Pacific region] a situation where self-acquisition … has

The justification for policies against self-acquisition focus on the principal-agent

relationship said to exist in the usual arms-length contract between an acquirer

and a merchant. As principal, an acquirer has the dual role of ensuring that

merchants conform with the scheme rules (though many merchants have

complained to the Reserve Bank that, because of confidentiality clauses, they are

prevented from actually seeing these rules), and standing in the settlement chain

between the merchant and the issuer. This dual role could, it is claimed, generate

two main risks if self-acquisition were permitted.

First, there would be no independent third party to enforce the scheme’s rules on

the merchant or to provide an independent check on merchant fraud, because the

self-acquirer would be playing both roles. Secondly, because there would be no

183 MasterCard International (2001), p 49.

184 Australian Bankers’ Association (2001b), p 64.

185 Visa International (2001d), p 2.

102

independent party standing between the merchant and issuers in the settlement

chain, issuers would be at greater risk. As noted earlier, if a particular good or

service is paid for using a credit card but is not delivered, the issuer would credit

the cardholder’s account and seek reimbursement from the acquirer under the

scheme’s chargeback arrangements; the acquirer, in turn, debits the merchant,

which has ultimate responsibility for repayment. If the merchant cannot pay, the

acquirer must do so. Both the merchant and the acquirer would have to fail before

the scheme’s loss-sharing arrangements needed to be invoked. However, in the

above example of a telephone company joining a credit card scheme as issuer and

acquirer, the merchant and the acquirer would be the same entity and the

independent guarantee to the issuer would disappear.

Several submissions have emphasised these types of risks in explaining why, in the

United States, a scheme refused to allow a retailer to use a bank which it owned,

and which was a member of the scheme, to acquire the retailer’s transactions.

Another case quoted was that of an airline whose acquirer required it to lodge a

bond to cover credit risks. The card scheme refused to let the airline avoid this

Others, however, have questioned the strength of the argument that acquirers ensure

merchants conform with scheme rules – exactly which rules are of concern has

not been spelled out. Merchants have commented that there is no policy prohibiting

self-acquisition in the debit card system in Australia where one merchant already

acquires its own transactions – though in limited circumstances – under the rules

of the Australian Payments Clearing Association. In any case, an acquirer is

contractually bound to conform to all rules in the respective card schemes, whether

it has membership as an ADI or, potentially, as a non-traditional participant.

Bankcard has rejected the arguments against self-acquisition and decided that it

will not prohibit this activity. It has done so on the basis that any institution that

passes its new membership requirements will, in the normal course, be able to

meet its obligations as acquirer. Bankcard’s expectation is that APRA, as prudential

supervisor, will ensure that a member is able to deal appropriately with any

particular risks that might arise. Where a member is not itself supervised, a guarantee

from an APRA-supervised institution is expected to ensure that other Bankcard

members will not be exposed to risks from that member’s acquiring activities

(including self-acquisition), should it fail.

In the Reserve Bank’s opinion, policies against self-acquisition are potentially

anti-competitive. If a large merchant were to become eligible for card scheme

membership, but was required to pass credit card transactions at its stores to another

186 Frontier Economics (2001), MasterCard International (2001).

103

acquirer, its competitive impact on the acquiring market would be constrained.

For this reason, the Reserve Bank believes that any outright prohibition by the

international card schemes on self-acquisition would not be in the public interest.

Rather, scheme policies should provide some flexibility in balancing safety and

competition concerns. The Reserve Bank acknowledges that acquirers can face

significant credit risks if their merchant base is concentrated on merchants – such

as airlines, theatres or Internet retailers – where payment is made before delivery

(eg airline tickets) or credit card signatures cannot be verified (eg phone

transactions). However, there is a wide range of credit card transactions that do

not have these characteristics. Credit risks would be much lower in the case of

service stations or supermarkets, for example – two areas where merchants could

be well placed to undertake an acquiring role.

The designated credit card schemes have separate sets of regulations which restrict

the range and scale of activities that card scheme members may undertake. These

involve:

• a requirement in the international card schemes that acquirers must also be

issuers and hence, broadly speaking, must be ADIs; and

• financial penalties or loadings in all three schemes on members that tend to

specialise in acquiring, rather than issuing.

MasterCard’s Bylaws require that once members are admitted to MasterCard, they

must issue and continue to issue a “reasonable” number of cards. Issuers that fail

to do so must pay an “Acceptance Development Fee” to MasterCard calculated on

the basis of each member’s ratio of acquiring volume to the total volume.

Visa’s “Balanced Portfolio Rule” states that:

“… the dollar value of acquired transactions by a member must be

no more than twice the dollar value of transactions for which the

same member is the issuer. Violations of this rule attract a financial

penalty of 0.03% of the volume of those transactions which exceed

This fee is paid by the acquirer to Visa.

187 Visa International (2001a), p 45.

104

Under its new rules, Bankcard allows members to specialise as issuers or acquirers.

It does, however, impose an “Incentive Fee” on members whose total volume of

transactions acquired is more than double the volume of transactions on cards it

has issued. This fee, paid to Bankcard, is 0.03 per cent of the value of transactions

acquired from the second year of Bankcard membership.

Although the details vary between the schemes, the effect of “net issuer” or

“balanced portfolio” rules is that members whose acquiring business is large relative

to their issuing business in a particular scheme must pay a loading to that scheme.

This raises their cost of providing acquiring services compared with other scheme

members and constrains their ability to compete. In the Reserve Bank’s opinion,

these rules are anti-competitive.

The card schemes have not sought to defend “net issuer” rules as being necessary

to protect the safety and integrity of the schemes. The rules and the loadings do

not address any of the specific risks facing card issuers and acquirers. The

justification, instead, is that such restrictions are necessary to foster the “balanced

development” of the credit card schemes. A number of arguments have been put

forward.

First, some submissions have argued that “net issuer” rules are needed because

specialist acquirers will attempt to “free ride” on the efforts of issuers; a scheme’s

claim that incentives are needed to encourage acquiring). Issuing is said to generate

relatively large externalities but also has relatively large costs; hence, it is argued,

has been offered to support the claim that externalities associated with issuing are

so much greater than for acquiring. In any event, the Reserve Bank has reached the

view, for reasons set out in Chapter 2, that claims of extensive externalities in

credit card networks are significantly overstated.

Allen Consulting Group has taken this argument further by claiming that present

levels of interchange fees in Australia “do not provide to issuers rewards for issuing

commensurate with the positive externalities to the respective schemes flowing

188 Australian Bankers’ Association (2001b), p 66.

105

acquirers that are not sufficiently large issuers; this penalty can be used by the

card schemes for promotion and will encourage members paying it to issue more

cards. There is, however, no evidence backing the assertion that card issuers have

not been appropriately rewarded for their efforts, and the argument ignores the

fact that card scheme members have always had the discretion to vary interchange

fees to achieve appropriate incentives.

The argument that “net issuer” rules are necessary to ensure balanced development

of credit card schemes was also put to the recent enquiry into competition in UK

have had some merit when the schemes were in their infancy and the primary

need was to promote cardholding but concluded that it was not clear how restricting

the supply of acquirers would serve to increase the number of cards in circulation.

A second argument is that specialist acquirers in Australia would have little interest

in promoting a particular credit card scheme, since they will typically offer

therefore required to ensure that such institutions contribute to the promotion of

the respective schemes. This argument fails to acknowledge that acquirers have a

clear interest in promoting any scheme for which they acquire, since without

transactions they earn no revenue. It also fails to acknowledge the merchant

perspective – competition amongst a larger number of acquirers, especially with

low-cost bases, would put downward pressure on costs and merchant service fees.

A more complex variation of the argument, put by Allen Consulting Group, is that

members that acquire but do not issue in one scheme, but which issue in another,

The Reserve Bank believes it is highly unlikely that a member of one scheme would

deliberately set out to undermine another of which it was also a member, while

trying to retain its merchant base.

Other submissions (though not from the international card schemes or their

members) have claimed that manageability and good governance require that

scheme members should issue as well as acquire; that is, governance will be more

difficult if members have markedly different interests. However, no practical

examples are given of governance issues that have been more efficiently resolved

because of the existence of “net issuer” rules.

190 Allen Consulting Group (2001), p 15.

191 Cruickshank (2000), p 241-242.

192 Bankcard (2001b), p 5.

193 Allen Consulting Group (2001), p 3.

106

The conflict of interest argument was also considered, and rejected, in the

Cruickshank Report. Cruickshank argued, to the contrary, that specialised acquirers

would be committed to maintaining the card schemes of which they were members

because their merchant customers are likely to continue to use those schemes and

they will have invested in the necessary infrastructure. In Cruickshank’s view, a

conflict of interest is more likely to exist if the same institution is both an issuer

and an acquirer.

A third justification for “net issuer” rules is that having members that are both

substantial issuers and acquirers can improve bargaining over interchange fees and

help ensure that the resulting fees are in the best interests of the schemes. Specialist

acquirers, it is argued, would have particularly strong bargaining power because

issuers have already invested heavily in the schemes; if so, interchange fees may be

issuers and acquirers, getting the interchange fee “wrong” (at least from the

members’ viewpoint) will not matter too much. The Joint Study confirmed that

the average cost per transaction is much higher for credit card issuing than for

acquiring, but no evidence has been provided that card issuers also have higher

sunk costs. Acquirers make substantial investments in terminals, networks and

switching facilities, and these investments are commonly cited by card scheme

members to justify Australia’s debit card interchange fees, which flow from issuers

to acquirers. The argument that members need to be both issuers and acquirers

also sits uneasily with the notion that interchange fees are determined by

A final argument, which was put to the UK banking review but not to the Reserve

Bank, is that it would not be “fair” to issuers that act as acquirers if non-issuers are

also allowed to acquire transactions. Cruickshank dismissed this argument on the

basis that card issuing “… is a profitable activity, not a social obligation”; the

argument was another that might have had some merit when the schemes were in

Notwithstanding the justifications offered by the international card schemes, the

ABA and others, confidential submissions by some scheme members have argued

for the removal of “net issuer” rules, which they claim are “onerous”. In their

view, the rules discourage small issuers from actively competing in the acquiring

market by markedly increasing their cost bases relative to large issuers. This leads

to outcomes which, the submissions claim, cannot be considered efficient.

195 Visa International (2001a), Executive Overview, p 2.

196 Cruickshank (2000), p 242.

107

197 Lea (2001).

In the Reserve Bank’s opinion, the justifications for “net issuer” rules in credit

card schemes do not outweigh their anti-competitive impact on the acquiring

market. That market is extremely concentrated in Australia; barriers to the entry of

non-financial institutions imposed by the card schemes are restrictive and every

indicator suggests profitability is very strong. Whatever contribution “net issuer”

rules might have made to their early development, the designated credit card

schemes are well-established in Australia and the rules now mainly serve to increase

acquiring costs for new scheme members and entrench the market power of

incumbents. From the public interest viewpoint, the consequence is that merchant

service fees are higher than they might otherwise be, the market is not contestable

by specialist acquirers that might have new skills and efficiencies to offer and

incentives for innovation and cost reduction are likely to be dampened; it is difficult

to claim, therefore, that the acquiring market is efficient in an allocative or dynamic

sense. The Reserve Bank has therefore concluded that “net issuer” rules are not in

the public interest and should be abolished.

The Reserve Bank also understands that, in response to the conclusion of the

Cruickshank Report that there is a lack of competition in the acquiring market in

the United Kingdom, MasterCard/Europay (UK) has removed its “net issuer” rules

In the Reserve Bank’s opinion, the current restrictions on access to the designated

credit card schemes in Australia, agreed to and applied by their Australian members,

create barriers to entry that are more restrictive than needed for the safety of these

systems, and hence unduly limit competition. The card schemes have not argued

against admission of new members as such – their rules make specific provision

for this – but that new members should, broadly speaking, be deposit-taking

institutions authorised and supervised by APRA. These are broad-brush

requirements, however, that do not directly address the particular risks generated

to the schemes by credit card issuers and acquirers. The Reserve Bank has therefore

concluded that a more liberal access regime, imposed under its payments system

powers, is needed in the public interest to promote competition and efficiency in

the provision of credit card services in Australia.

one that the Reserve Bank considers appropriate, having regard to the public interest,

the interests of current participants, the interests of institutions who, in the future,

108

may want access to the system and any other matters the Reserve Bank considers

relevant.

The Reserve Bank’s proposed access regime seeks to promote competition and

efficiency, without compromising the safety of the designated credit card schemes,

by ensuring that membership restrictions:

• do not inhibit competition more than is necessary to protect the financial

soundness of the schemes;

• are clearly targeted at the risks incurred by credit card issuers and acquirers;

and

• do not discriminate between members whose business is focused on issuing

or acquiring.

In so doing, the proposed access regime meets the intent of the Wallis reforms

that non-traditional institutions participate in the payments system as a means of

spurring competition.

Deposit-taking institutions authorised and supervised by APRA are eligible for

membership of all three credit card schemes operating in Australia. The Reserve

Bank has concluded that restrictions on the basis of institutional status – that

members be deposit-taking institutions – are excessive; ADIs in Australia have

traditionally undertaken a wide range of banking business of which participating

in four party credit card schemes has usually been a small part. At the same time,

the Reserve Bank acknowledges that reliance on APRA’s prudential supervision of

members has lent some objectivity to, and reduced the costs of, membership

procedures in credit card schemes.

To preserve these benefits, and to assist in promoting competition in credit card

schemes, the APRA Board has agreed in principle that APRA will authorise and

supervise specialist credit card issuers and acquirers. To this end, a regulation will

acquiring to be “banking business”; this matter is being progressed with the

Treasury. Any specialist institutions wishing to undertake the “banking business”

of issuing credit cards and/or acquiring credit card transactions in four party credit

card schemes will need to obtain an authority from APRA and be subject to its ongoing

supervision. As an assurance to the credit card schemes and the community

generally that such institutions have the necessary competence and financial

standing, they will need to:

• be established as special purpose vehicles with a separate corporate identity;

• be separately capitalised. The adequacy of start-up capital will be assessed on a

case-by-case basis having regard to the scale of operations proposed;

109

• demonstrate to APRA that they are of financial substance and able to meet their

settlement obligations;

• have in place appropriate risk management policies, particularly controls for

monitoring credit risk, IT risk and liquidity risk; and

• meet prudential standards, as determined by APRA, in relation to credit quality

and liquidity management that are no less strict than would apply to an ADI’s

credit card business.

The proposed access regime is therefore consistent with the objectives of the credit

card schemes that their members have sufficient financial substance to undertake

credit card activities. It specifically targets the risks generated by credit card issuing

and acquiring and so does not compromise safety and stability. Since all scheme

members will continue to be authorised and prudentially supervised by APRA,

there are no particular implications for the international card schemes. The access

regime does not prevent continued co-branding or outsourcing arrangements but

it does allow institutions participating in those arrangements to participate directly,

if they are prepared and able to meet APRA’s requirements. It also obviates the

need for non-traditional participants to seek guarantees from ADIs which might

otherwise be competitors in credit card acquiring and issuing.

The proposed access regime precludes any outright prohibition in the designated

credit card schemes on participants acquiring their own transactions. The Reserve

Bank believes the sensible way for credit card schemes to proceed on this issue is

on a case-by-case basis. As a minimum, however, the schemes’ regulations and

policies must have sufficient flexibility to accommodate proposals by participants

wishing to self-acquire that address the particular risks involved.

Finally, the proposed access regime precludes any “net issuer” rules, and associated

financial penalties or loadings, in the designated credit card schemes. The Reserve

Bank has concluded that these rules do not contribute to the control of risks in

credit card acquiring but act to protect the dominant position of the four major

banks in the acquiring market. These restrictions on competition are not in the

public interest.

The proposed access regime is set out below.

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2. This Access Regime applies to the three credit card systems designated

on 12 April 2001 by the Reserve Bank of Australia under Section 11 of

(i) the credit card system operated within Australia known as the

Bankcard Scheme;

(ii) the credit card system operated within Australia known as the

MasterCard System or MasterCard Network Card System; and

(iii) the credit card system operated within Australia known as the Visa

System or the Visa Network Card System,

each referred to as follows as a Scheme.

3. In this Access Regime:

an “acquirer” provides services to merchants to allow the merchant to

accept a Scheme’s credit cards;

an acquirer is a “self acquirer” if it or a related body is the merchant in a

transaction;

“credit card transaction” or “transaction” means a transaction between a

credit card holder and a merchant involving the purchase of goods or

services on credit by that credit cardholder using a credit card;

an “issuer” issues a Scheme’s credit cards to its customers;

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“rules of a Scheme” or “rules” include the constitution of a Scheme, rules,

by-laws, procedures or any arrangement in relation to a Scheme by which

participants in the Scheme in Australia may consider themselves bound;

a “Scheme’s credit card” is a credit card issued in accordance with the

rules of that Scheme;

a “Scheme Administrator” is the administrator of the Scheme, if any;

use of a credit card includes use of a credit card number.

4. This Access Regime is to be interpreted:

• in accordance with its objective; and

• by looking beyond form to substance.

5. This Access Regime comes into force on [ ].

6. Any person supervised by the Australian Prudential Regulation Authority

(APRA) as an authorised deposit-taking institution or as a specialist credit

card service provider must be eligible to participate in a Scheme in

Australia.

7. The rules of a Scheme must not discriminate between authorised deposittaking

institutions and specialist credit card service providers supervised

by APRA in relation to the rights, obligations and entitlements of such

participants in the Scheme.

8. The rules of a Scheme must not prevent a participant from being:

(i) an issuer; or

(ii) an acquirer; or

(iii) both an issuer and an acquirer.

9. The rules of a Scheme must not impose on a participant in a Scheme any

fees, charges, loadings or any form of penalty as a consequence of, or

which are related in any way to, a difference in the value or number of

transactions in which that participant is the acquirer in comparison to

the value or number of transactions that involve the use of credit cards

issued by that participant.

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10. The rules of a Scheme must not prohibit a participant from being a self

acquirer if the participant can establish to the reasonable satisfaction of

the Scheme Administrator or, if none, to a majority of the participants in

the Scheme that it has the capacity to meet the obligations of an acquirer

as a self acquirer. The rules of a Scheme may allow the decision on the

capacity of a self acquirer to meet its obligations to be reviewed by the

Scheme Administrator or, if none, by the participants in the Scheme upon

the giving of reasonable notice to that self acquirer.

11. The Scheme Administrator or, if none, participants in the Scheme must

publish the rules of a Scheme which govern the eligibility for participation,

and the terms of participation, in the Scheme in Australia on the Scheme

Administrator’s website or, if none, on another relevant website.

12. The Scheme Administrator or, if none, each of the participants in the

Scheme must give a person that has applied to participate in the Scheme,

and who is eligible to participate under paragraph 6 of this Access Regime,

reasons in writing if the application is rejected.

13. The Scheme Administrator or, if none, each of the participants in the

Scheme must give the Reserve Bank of Australia prior notice in writing

of any proposed changes to its rules governing the eligibility for

participation, and the terms of participation, in Australia.

Reserve Bank of Australia

SYDNEY

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The main regulations in the Bankcard, MasterCard and Visa credit card schemes in

Australia – dealing with the collective setting of interchange fees, restrictions on

merchant pricing and restrictions on entry – have been assessed in previous Chapters

on public interest grounds. Each of these regulations represents significant

departures from the normal workings of the market.

This final Chapter draws the previous analyses together by reviewing the regulations

and their consequences against the benchmarks that underpin the public interest

test, and summarising the public interest concerns. These concerns provide the

background for the use of the Reserve Bank’s payments system powers to promote

reform of the designated credit card schemes, in the interests of promoting

efficiency and competition in the Australian payments system. The Chapter outlines

the reform measures and their likely impact. It then analyses the main objections

to reform that have been raised and concludes that they are not a persuasive defence

The last section outlines the next steps in the Reserve Bank’s consultation process

before its proposed standards and access regime are finalised.

To meet the broad objectives of public policy, the payments system in Australia

would be expected to be responsive to competitive pressures, including freedom

of entry into the markets for different payment instruments, provided the safety

of the system is not compromised. There is likely to be a role for private-sector

regulations to ensure the safety, technical consistency and orderly operation of

any payment system, but such regulations should not be so binding or widespread

as to compromise the market process. For these reasons, the Reserve Bank specified

a number of benchmarks as underpinning the public interest test in the payments

system. The benchmarks, set out in Chapter 1, are that:

• relative prices charged by financial institutions to consumers who use payment

instruments should take into account the relative costs of providing these instruments;

• merchants should be free to set prices for customers that promote the

competitiveness of their business;

• prices of payment instruments should be transparent;

114

• any restrictions on the entry of institutions to a payment system should be the

minimum necessary for the safe operation of that system; and

• competition between different payment systems should be open and effective.

Previous Chapters have discussed how the regulations of the designated credit card

schemes depart from these benchmarks, and whether such departures can be

defended in the public interest. Summarising, and taking the benchmarks in turn:

• in the designated credit card schemes, the cardholder faces no transaction fees,

and may be paid for using the card by accumulating points in a loyalty program,

even though this payment instrument is among the most expensive for financial

institutions to provide and for merchants to accept. Credit card schemes and

their members have argued that this pricing structure is essential for the growth

of credit card networks and for maximising community welfare;

• because of card scheme restrictions, merchants in Australia are prevented from

recovering their credit card costs from cardholders. These restrictions harm

consumers who do not use credit cards and suppress price signals about the

costs of alternative payment instruments. Again, credit card schemes and their

members have argued that these restrictions are essential for the growth of

credit card networks;

• merchants are at a disadvantage in negotiating with acquirers because merchant

service fees are not posted by acquirers, but are negotiated bilaterally between

a merchant and its acquirer and are closely held as commercial secrets. As a

result, merchants cannot easily compare the range of fees on offer without

incurring what could be significant search costs. This point is taken up below.

Interchange fees, of course, are the key determinant of fees paid by merchants

and credit cardholders, and the processes by which interchange fees have been

set within the respective card schemes in Australia have lacked any transparency;

• card scheme requirements that new members should, broadly speaking, be

deposit-taking institutions supervised by APRA are broad-brush requirements

that do not directly address the risks to the schemes generated by credit card

issuers and acquirers. The regulations may achieve their desired effect but, by

excluding other potentially well-qualified institutions, they create barriers to

entry that are higher than needed to preserve safety; and

• finally, the major banks that dominate the designated credit card schemes are

also the dominant providers of competing payment instruments such as debit

cards, cheques and direct debits. They have a strong influence on setting the

fees and conditions in nearly all parts of the retail payments system. These are

the circumstances in which the payment instrument which is among the most

115

costly for merchants to accept – ie the credit card – and for which there are

ready substitutes is the one which is most actively promoted by financial institutions.

Reviewed against the competition benchmarks, the regulations established by the

designated credit card schemes raise three particular concerns from a public interest

viewpoint. The first is the current arrangements for the collective setting of

interchange fees. These arrangements are characterised by their rigidity and lack

of transparency – Bankcard’s interchange fee, for example, has not changed in

27 years – and the absence of any formal methodology for determining these fees.

The second concern, in which interchange fees play a critical role, is the inefficiency

of credit card pricing. Aside from annual fees, credit cardholders who do not use

the revolving credit facility do not contribute to the costs of providing credit card

payment services; instead, they receive a substantial subsidy in that they are provided

with these payment services at a price below cost. Credit cardholders who use the

revolving credit facility and merchants, through the interchange fee, cover the

costs of credit card schemes. Merchants’ costs of accepting credit cards are, in

turn, passed onto the community as a whole in the form of higher prices of goods

and services. As noted in Chapter 2, credit card schemes and their members have

argued that the subsidy is needed to encourage consumers to join credit card

schemes, and use their cards, so that network externalities are realised. This

argument suggests that the network externalities are so large as to justify cardholders

being charged negative fees (ie being paid by issuers) to use their credit card. The

evidence, however, is that network externalities are small, if they exist at all.

Furthermore, any claim that the interchange fee must continue to generate negative

fees to cardholders if they are to use credit cards is difficult to reconcile with the

card schemes’ claim that cardholders derive significant benefits from credit card use.

This inefficiency in the pricing of credit card services is reinforced by card scheme

restrictions on merchant pricing that shield credit cardholders from directly facing

the costs of transactions that they undertake. Card scheme members are able to

generate their own set of incentives for credit card use through the use of loyalty

programs, while denying merchants the right to offer incentives to promote their

competitive interests. The consequence is a misallocation of resources in the

Australian payments system.

The third public interest concern is the lack of competition in the credit card market,

and between payment networks more generally. The Reserve Bank acknowledges

the need for minimum entry standards to ensure the safety of the designated credit

card schemes. However, restrictions on entry in their current form serve mainly to

116

entrench the market power of incumbents and do not contribute to the allocative

or dynamic efficiency of the credit card market. In the acquiring market, in

particular, the restrictions have kept merchant service fees higher than they might

otherwise be and have helped to deny acquirers as a group an independent and

effective voice in interchange fee setting.

Given these concerns, the Reserve Bank believes that the regulations of the

designated credit card schemes suppress or distort the normal market mechanisms

in ways that are not conducive to maximising community welfare. The community

cannot be confident that the price mechanism is allocating resources efficiently to

meet the demand for different payment instruments or that the credit card market

is sufficiently contestable to ensure that card scheme members earn no more than

a competitive return on their investments over time.

The Reserve Bank has therefore set out a reform of credit card schemes that involves:

• an objective, transparent and cost-based methodology for determining interchange fees;

• freedom for merchants to recover from cardholders the cost of accepting credit cards; and

• a more liberal access regime that allows for the entry of specialist credit card

service providers, both issuers and acquirers, to be supervised by APRA.

In the Reserve Bank’s opinion, this package of measures will promote a more

efficient and lower-cost payments system in Australia, from which the community

as a whole will benefit. The reform measures have been endorsed by the Payments

System Board of the Reserve Bank.

The Reserve Bank’s proposed standard on interchange fees is likely to result in a

significant reduction in the level of interchange fees in Australia, although the

specific outcomes must await the costings to be carried out by the designated

credit card schemes. Since interchange fees effectively set a floor for merchant

fees are passed through to the final prices of goods and services. Merchants would

also be free to recover their merchant service fees from cardholders on a “fee for

service” basis; to the extent that this occurs, the costs of accepting credit and charge

cards would no longer be reflected in the prices of all goods and services.

117

Reform of credit card schemes will also have a direct impact on credit cardholders

and is likely to result in some re-pricing of credit card payment services. However,

this is the means by which the price mechanism is to be given greater rein in the

credit card market. A movement towards a “user pays” approach to credit card

payment services would be consistent with the approach adopted by Australian

financial institutions in pricing other payment instruments under their control. As

the ABA itself has confirmed: “Pricing services efficiently provides consumers with

choice to use lower cost distribution channels and, therefore, facilitates a more

The principles that consumers should face prices that take into account the relative

costs of producing goods and services, as well as demand conditions, and that

resources should be free to enter a market in response to above-normal profit

opportunities, have been the guiding principles for tariff reform and market

deregulation in Australia. Such market reforms may impact unevenly on different

groups – some gaining, some losing – but they are now the well-established route

to more efficient use of resources in the Australian economy.

In submissions to the Reserve Bank, credit card schemes and their members have

argued against any reform that would have the effect of reducing interchange fees

and issuing revenues from this source. The arguments claim that reform will have

three main “unintended consequences”:

• it will give an unfair competitive advantage to the three party card schemes,

American Express and Diners Club;

• small credit card issuers will be disadvantaged and overall competition in the

credit card market may be reduced; and

• consumers will not benefit because merchants will not pass on lower merchant

service fees resulting from lower interchange fees.

The credit card schemes and their members have argued that, as a matter of

principle, it is inappropriate for the Reserve Bank to set a standard for interchange

fees in the designated credit card schemes without also “regulating” the three party

such a standard as asymmetric regulation which is “applied to a firm or group of

firms due to some characteristic that distinguishes them from unregulated firms

198 Australian Bankers’ Association (2000), p 8.

199 Visa International (2001b), MasterCard International (2001), Australian Bankers’ Association

(2001c) and Australia and New Zealand Banking Group (2001b).

200 Visa International (2001b), p 11.

118

between the designated credit card schemes and the three party card schemes with

respect to interchange fee setting. In the Bankcard, MasterCard and Visa credit card

schemes, interchange fees are set collectively by the financial institutions that are

members of these schemes, but that are otherwise competitors in providing credit

card services to cardholders and merchants. The ACCC has reached the view that

American Express and Diners Club, on the other hand, do not have collectively

or “implicit” interchange fee is not relevant; the three party card schemes do not

have a process under which competitors collectively agree to set a price which

then affects, in a uniform way, the prices each of the competitors charges to third

parties. For this reason, the Reserve Bank saw no case on public interest grounds

to designate the three party card schemes to deal with issues relating to collective

fee setting (or restrictions on entry). However, the three party card schemes impose

the same restrictions on merchant pricing as the designated credit card schemes.

The Reserve Bank will therefore be consulting with the three party card schemes

on why they should not meet the proposed standard on merchant pricing.

Submissions have also argued that a standard for interchange fees in the designated

credit card schemes will prevent these schemes from being able to compete

effectively with the three party card schemes. This raises the question of the nature

of competition between four and three party card schemes in Australia

On the basis of network size, the four party credit card schemes would appear to

have a dominant market position compared with the smaller three party card

schemes. Visa has argued that there are significant network effects in credit card

schemes and that the size of its network makes it particularly appealing to both

cardholders and merchants: “… the fact that more merchants accept VISA than

AMEX means that consumers facing the same terms and conditions of use for

each card would prefer to carry a VISA card than an AMEX card. Similarly, the fact

that there are more VISA cardholders makes accepting VISA cards more attractive

to merchants than accepting AMEX cards, even if the terms and conditions of

the four party card schemes have a position of network dominance in Australia.

Firstly, Bankcard, MasterCard and Visa account for around 92 per cent of credit

201 Some submissions have pointed out that AMP Bank issues American Express cards and is paid

a fee which appears similar to an interchange fee. However, this fee is one that is negotiated

bilaterally between American Express and AMP Bank.

202 Visa International (2001a), p 3.

119

and charge cards on issue, and for around 85 per cent of the value of credit and

charge card transactions. Secondly, around 85 per cent of American Express or

Diners Club cardholders also have a Bankcard, MasterCard or Visa credit card but

only around ten per cent of cardholders in these latter schemes also have an

Australia that accept cards issued by members of the four party credit card schemes

appears to be about double the number of merchants that accept American Express

Network dominance in this form places the designated credit card schemes at the

centre of the credit and charge card market in Australia. Their behaviour will have

a significant impact on market outcomes, particularly compared to the behaviour

of the three party card schemes that lack network size. If a standard for interchange

fees resulted in lower merchant service fees in the designated credit card schemes,

normal competitive processes would ensure that competitors would have to react.

Merchants would have an even stronger preference than at present for cards of the

four party card schemes. They would be likely to seek to renegotiate merchant

service fees charged by American Express and Diners Club; alternatively, if fees did

not adjust, some might stop accepting the latter cards altogether, a viable option

because merchants may not fear losing many sales in view of the relatively small

network size of American Express and Diners Club. These schemes would therefore

be under strong competitive pressure to respond by lowering their merchant service

fees to protect their merchant base.

This sequence of competition has already played out in the United States. In earlier

work sponsored by Visa, Evans and Schmalensee describe the revolt of Boston

restaurants to the relatively high merchant service fees of American Express – an

incident dubbed the “Boston Fee Party” – following which American Express

reduced its average merchant service fees from 3.22 per cent to 2.74 per cent

between 1990 and 1996. Evans and Schmalensee argue that “American Express

decreased its merchant discount as a result of competition from Visa and other

In a recent submission, however, Visa has suggested that the nature of competition

between the four and three party card schemes is quite different. It has argued

203 Roy Morgan Research.

204 “There would seem to be two possible reasons for this low penetration rate. The first is that

merchant service fees for American Express are too high, so merchants select lower cost

methods, such as VISA. Alternatively, one might argue that merchants do not feel as much

need to accept American Express because there are fewer cardholders for this card. Both of

these reasons are likely to have some validity.” Visa International (2001a), p 32.

205 Evans and Schmalensee (1999), pp 171-172.

120

that three party card schemes are likely to have more market power, not less, relative

fees that results in a fall in issuers’ revenues would mean that issuers would no

longer be able to offer loyalty programs with the previous levels of rewards.

Competition between acquirers in the four party schemes would push merchant

service fees in these schemes down in line with interchange fees, but Visa argues

that the three party card schemes, even if subject to strong competitive pressures,

would not be forced to match these reductions. The reasoning is that the three

party schemes would have no incentive to change their prices to merchants and

cardholders because they had already set them to maximise their profits; hence,

the three party schemes would retain an income stream from merchants that would

allow them to continue to offer loyalty programs with unchanged levels of rewards.

The result would be a shift of cardholders to card schemes able to offer the most

generous loyalty programs.

In the Reserve Bank’s opinion, this analysis provides only a selective view of the

competitive process and suffers from significant flaws:

• the analysis assumes that the three party card schemes can set their merchant

service fees without any reference to the fees charged by the members of the

designated credit card schemes. The proposition that three party card schemes

have completely independent pricing power is difficult to reconcile with the

standard observation that the price of close substitutes is a key determinant of

• the analysis assumes a particular sequence in the competitive responses to lower

merchant service fees, but no theoretical or empirical support is provided for

this sequence. In particular, it assumes that the immediate response is that

cardholders in the four party credit card schemes switch to the three party

schemes and this, in turn, gives the latter schemes leverage over merchants.

However, if merchants are equally prompt in renegotiating fees in the three

party schemes, which would have become even more expensive to them, the

latter schemes would have much less scope to attract cardholders. Normal

competitive pressures would force the three party schemes to respond to the

fall in merchant service fees by their competitors and they would therefore

face the same need to review their loyalty programs; and

206 Visa International (2001b), p 12. This differs from an earlier claim by Visa that the three

party card schemes very likely lack market power. Visa International (2001a), p 24.

207 This argument has also been rejected by Access Economics, consultants to American Express:

“This proposition is unsustainable and it should be clear that, to the extent that the

three-party schemes are close substitutes for four party cards, there will be a flow-on of any

reductions in merchant service charges from regulation.” Access Economics (2001), p 26.

121

• the analysis assumes that scheme restrictions on merchant pricing remain in

force, denying merchants the freedom to recover from cardholders the cost of

accepting credit and charge cards. The Reserve Bank’s draft standard on merchant

pricing – on which the Reserve Bank will be consulting with the three party

card schemes as well – will give merchants that freedom. This has important

implications for the degree of “merchant resistance” to accepting credit and

charge cards. If merchants recover their costs from cardholders, the current

gap in merchant service fees between the four and three party card schemes –

and any widening in that gap – would be transparent to cardholders and, other

things being equal, cardholders would continue to prefer the lower-cost option.

Under these circumstances, it would be much more difficult for the three party

schemes to maintain higher merchant service fees in the face of competition.

The ABA has identified other consequences that it claims would flow from any

reduction in interchange fee revenues in the designated credit card schemes. First,

it has argued that issuers will increase fees to cardholders, leading some cardholders

to give up their credit cards because “by the reduction of interchange fees, the

cardholders currently pay no price (and may earn rebates) for the payment services

of a credit card, this argument would seem to confirm the inefficiency in current

credit card pricing. The ABA claims that some credit cardholders will move to the

three party schemes; however, it does not explain why such cardholders, who to

date have chosen not to, would be prepared to pay the higher joining and annual

efficient pricing signals, would not make greater use of other payment instruments

such as debit cards or direct debits.

208 The ABA argues that this will result in “fewer cardholders, fewer purchase transactions, an

advantage to three-party charge card networks and cardholders that no longer have access to

credit”. Australian Bankers’ Association (2001c), pp 4-5.

209 The recent US district court judgment on the “exclusionary” rules of the international credit

card schemes noted the advantages that a financial institution has in marketing credit cards to

existing customers as part of a suite of financial services. “All else being equal … customers

are significantly more likely to choose a card offered by their primary financial institution

than any other institution.” US District Court, Southern District of New York, 98 Civ. 7076

(BSJ), p 117.

210 The ABA estimates that credit card annual fees would move from an indicative level of $15 pa

to $42 pa if interchange fees were to fall to 0.4 per cent. Australian Bankers Association

(2001c), p 4. The American Express green card has a joining fee of $30 and an annual fee of

$65; Diners Club has a joining fee of $30 and an annual fee of $95. This comparison assumes

that the three party card schemes would not have to adjust their cardholder fees in the face of

downward pressure on their merchant service fees.

122

Secondly, the ABA has argued that because issuers would need to recover a higher

portion of issuing costs from cardholders, it would be unlikely that all current

cardholders would qualify for a credit card. The implication of this argument,

however, is that current interchange fee revenues could be allowing issuers to

provide cards to cardholders who would not meet the normal requirements for

unsecured credit. Thirdly, the ABA has claimed that “merchants with high fraud

would be dropped and the universal payment guarantee would be curtailed to

merchants or groups of merchants whose historical transactions had generated

not universal; merchants accepting “card not present” transactions, such as

purchases over the phone or Internet, receive no such guarantee. In any event, the

Reserve Bank’s draft standard allows fraud costs incurred by issuers in providing

payment guarantees to be included in interchange fees. By making these fraud

costs transparent, moreover, card scheme members and merchants will have a

stronger incentive to address these costs.

In the ABA’s view, the outcome of a standard for interchange fees would be reduced

credit card transactions and higher average transaction costs in credit card networks.

It has argued that either one scheme member will dominate both issuing or

acquiring (and thus the schemes would look like a three party scheme) or that a

few financial institutions could come together to form their own credit card

company. However, the ABA has offered no evidence as to why the first outcome

might result, and why it has not done so already; nor has it explained how the

second outcome would differ from the current four party credit card schemes, in

which the four major banks are dominant.

In summary, the Reserve Bank is unpersuaded by the arguments that reform of the

designated credit card schemes constitutes a regulatory bias that favours the three

party card schemes, American Express and Diners Club. No convincing reasons

have been provided why private-sector regulations in the dominant credit card

networks are to be preferred, in the public interest, to publicly-determined standards

that promote efficiency and lower costs in the payments system. The way in which

competitive forces will play out between credit cards, charge cards and other

payment instruments will depend on how cardholders and merchants react to more

efficient price signals. Credit cardholders faced with fees more closely aligned to

the costs of providing credit card services can be expected to make a more efficient

choice between payment instruments; as well, lower merchant service fees offered

by members of the designated credit card schemes will give merchants a stronger

negotiating position in their dealings with the three party card schemes. Such

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responses will promote a more efficient allocation of resources and a reduction in

overall costs in the Australian payments system.

A number of submissions have argued that, because of economies of scale in issuing,

many of the smaller credit cards issuers are only breaking even on this activity and

any reform that results in a reduction in interchange fee revenues will make their

liberalising access to the credit card schemes will result in an overall decline in

competition because, with lower interchange fees, new institutions will not be

attracted to card issuing.

The credit card market is similar to industries such as telecommunications and

airlines, where there is scope to exploit economies of scale. Such industries are

characterised by large fixed costs that, when spread over an increasing volume of

output, result in declining per unit costs of production. Large firms in these

industries can therefore run a profitable business at lower prices than a small firm.

For competition authorities, the potential benefits to consumers of having a small

number of larger firms, able to take advantage of economies of scale to reduce

their prices, normally need to be weighed against possible exploitation of market

power by these firms.

Evidence of economies of scale in credit card issuing comes from the highly

concentrated structure of issuing in Australia. Figure 5.1 shows the market share

of the four major banks in transactions with bank-issued cards since the mid 1990s.

The entry of new issuers has made little inroads into market concentration. In a

confidential submission, the ABA has presented data showing that a sample of

small issuers incurs higher costs and enjoys lower margins per card than an industry

in card issuing.

The key point, however, is that the existence of economies of scale is not an

argument for keeping interchange fees high to enable smaller issuers to remain in

the market. Such an argument confuses “competition” with the number of

competitors. Turned around, it implies that community welfare would be enhanced

if interchange fees were raised so as to make issuing profitable for institutions that

212 Australian Bankers’ Association (2001b), Visa International (2001b) and Australia and New

Zealand Banking Group (2001a).

213 These data are not directly comparable with those in the Joint Study, which showed costs and

revenues per transaction rather than per card.

124

would otherwise not break even. This might result in more issuers, but probably

at the highest cost end. It would be a perverse result of competition if entry into

prices. The objective of the Reserve Bank’s proposed access regime for the designated

credit card schemes is to facilitate entry by non-traditional institutions that may

have the scale, skills and infrastructure to compete with established participants.

Entry or the threat of entry by such institutions is likely, over time, to provide the

main spur to competition in the credit card market.

Concerns have also been raised that any reduction in interchange fees, and hence

in merchant service fees, would simply increase merchants’ profits and would not

per cent of number of transactions

80

82

84

86

80

82

84

86

% %

1994 1995 1996 1997 1998 1999 2000

Source: Reserve Bank Transaction Cards Statistical Collection.

125

be passed onto consumers through the prices of goods and services. The basis for

these concerns is a claim that the merchant sector is not competitive.

The pass-through of any reduction in interchange fees to the prices of goods and

services has two stages:

• the pass-through of lower interchange fees to merchant service fees; and

• the pass-through of lower merchant service fees to final prices.

The extent of pass-through at each stage is determined by the degree of competition

fees to consumers is unlikely to be true. Even a monopolist will pass through to its

customers some part of a fall in the cost of its inputs; the more competitive a

market, however, the more a fall in costs will be passed through into final prices.

The pass-through of lower interchange fees to merchant service fees will depend

on the degree of competition in the credit card acquiring market and the threat of

new entry. Although there is no indication that interchange fees themselves have

responded to changing cost conditions, acquirers argue that competition would

market share to acquirers offering lower merchant service fees. The more intense

is competition, the more likely it is that acquirers will pass through fully any

reduction in interchange fees.

For reasons discussed in Chapter 4, however, competition in the credit card

acquiring market is not as vigorous as it could be in Australia. One factor which

has important implications for pass-through is the lack of transparency in

interchange fees and merchant service fees. In retail financial services, interest rates

and transactions fees are transparent and readily comparable across financial

institutions, and individual institutions do not usually price discriminate between

their customers. For merchants, however, the provision of financial services –

whether it be lending or acquiring services – is negotiated on a case-by-case basis

and pricing is not transparent. Larger firms with higher transaction volumes can

need to be active in seeking quotes from acquirers to ensure they have achieved a

competitive merchant service fee. The recent publication by the ARA of the range

214 See Australian Retailers Association (2001b) for a discussion of how interchange fees affect

merchant service fees.

215 Evidence for this is presented in Table 4.3 of this document.

216 Australian Retailers Association (2001a).

126

interchange fees under the Reserve Bank’s draft standard, will help to ensure that

merchants are better informed when they enter the negotiating process with

acquirers. Nonetheless, the significant search and adjustment costs involved for

merchants may limit the pressure on acquirers to reduce merchant service fees for

all merchants, particularly small ones.

The pass-through of lower merchant service fees to the final prices of goods and

services will depend on the degree of competition in the retailing sector. On a

range of evidence, including market concentration and profit margins, the retail

market concentration. In a confidential submission, the ABA has claimed that

“[r]etailing in Australia is very concentrated – considerably more so than banking”.

There is no empirical evidence for this claim. While it is true that Coles Myer and

Woolworths have a large share of the grocery market, grocery items account for

data on retail trade indicate that large businesses account for just 56 per cent of

contrast, just three banks represent a market share well above 56 per cent of credit

card issuing. On this evidence, retailing is much less concentrated than the credit

card market.

As to profit margins, staff from the Productivity Commission have concluded that

“[w]holesale and retail trade have the lowest profit margins of all Australian

retail trade, at around 3 per cent, are low compared with the average for all

industries of around 9 per cent. The same ABS data show that profit margins for

figures do not, of course, take into account the different risk profiles of the

industries, but they do suggest a highly competitive retail sector.

217 MasterCard International (2001) has acknowledged that “competition at this [retail] level

appears to be robust in Australia.” p 19.

218 Excluding motor vehicles. ABS Catalogue 8624.0.

retailers but only a sample of small retailers. The definition of large businesses for this

purpose varies depending on the state and the industry, but is based on the number of

employees. It includes, among others, all department stores, 85 per cent of supermarkets and

grocery stores, 65 per cent of clothes and soft goods retailing and 57 per cent of household

goods retailing. All Coles Myer and Woolworths businesses are included in the “large

businesses” category.

221 ABS Catalogue 8140.0. The profit margin is calculated as the percentage of operating income

available as operating profit.

127

On the available evidence, the Reserve Bank is confident that, where merchants do

not pass reductions in merchant service fees onto credit cardholders on a “fee for

service” basis, competitive pressures will ensure that merchants pass these

reductions through to the prices of final goods and services. The pass-through

may not, of course, be readily apparent. The cost of accepting credit cards is

embedded in a myriad of retail prices and the impact of lower merchant service

fees on individual prices may not be obvious; moreover, to the extent they offset

cost increases from other sources, lower merchant service fees may have the effect

of tempering price increases that would otherwise have taken place.

The Reserve Bank is issuing its standards and access regime for the designated

presentations, on the draft standards and access regime before they are finalised.

Comments and details of contact persons should be submitted by 15 March 2002

to:

Head of Payments Policy

Reserve Bank of Australia

GPO Box 3947

SYDNEY NSW 2001

or to creditcards@rba.gov.au

The Reserve Bank acknowledges that measures to promote efficiency and

competition in the credit card market in Australia will have important implications

for the pricing of other payment instruments, particularly debit cards. The Joint

Study concluded that interchange fees in Australia’s debit card system, which are

determined bilaterally and flow from card issuers to acquirers, do not have a

convincing rationale. Several submissions to the Reserve Bank have argued that

debit card interchange fees should be reformed at the same time as those for credit

cards, so that consumers and merchants can face more efficient prices for both

payment instruments. The Reserve Bank agrees that this is a desirable objective,

but it has not been prepared to slow the timetable for reform of the credit card

market. In any event, the introduction of more efficient pricing arrangements for

debit cards is, in the first instance, a matter for industry participants. The Reserve

Bank remains willing to work with participants to this end.

The Reserve Bank has also been in discussion with Visa, and Visa members issuing

the Visa-branded debit card, about the current practice under which these issuers

earn credit card interchange fees for what are essentially debit card transactions.

128

The Reserve Bank has advised Visa and issuing members that this practice imposes

an inappropriate burden of costs on merchants and has no place in the Australian

payments system. Issuing members have begun work on an interchange regime to

address the issues raised by the Reserve Bank; at the same time, they have expressed

concern about the impact on their net revenues if changes to the current practice

were to precede reform of the debit card market more generally.

129

American Express International

AMP Bank Limited

Australia and New Zealand Banking

Group Limited

Australia Post

Australian Association of Permanent

Building Societies (AAPBS)

Australian Consumers’ Association

Australian Bankers’ Association

Australian Retailers Association

Bankcard Association of Australia

Bank of Western Australia Limited

Bendigo Bank Limited

(combined views)

Citibank Limited

Coles Myer Limited

Commonwealth Bank of Australia

Credit Union Services Corporation

(Australia) Limited (CUSCAL)

Diners Club Australia

Integral Energy

MasterCard International

Motor Trades Association of Australia

National Australia Bank

Newcastle Permanent Building

Society

Restaurant and Catering Association

of Australia

St George Bank Limited

Sydney Water

Telstra

The Shell Company of Australia

Limited

TransAction Resources Pty Ltd

Visa International Service Association

Westpac Banking Corporation

Woolworths Limited

In addition, the Reserve Bank received submissions from a small number of

individuals.

130

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131

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132

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133

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