The impact of the options considered by the Reserve Bank would fall, in different ways, on the following parties:

(i) the community as a whole, including consumers who do not use credit cards;

(ii) credit cardholders;

(iii) merchants that accept credit cards for payment; and

(iv) the credit card schemes and financial institutions which are members of these schemes.

In the absence of regulatory action by the Reserve Bank, credit card scheme

restrictions that suppress or distort the normal market mechanisms would in all

likelihood remain largely in place. Neither MasterCard nor Visa has proposed

changes to its current membership criteria or to its restrictions on merchant pricing.

While Bankcard has liberalised its membership criteria to allow for non-traditional

participants (provided they are guaranteed by a supervised financial institution),

the potential competitive impact of a new entrant to Bankcard is significantly limited

if that entrant cannot also participate in the international credit card schemes. The

designated credit card schemes and their members have not indicated a willingness

to consider any significant reduction in interchange fees, which underpin current

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

however, it is not possible to anticipate the proposals that might be made if the

schemes were to seek authorisation of their interchange fee arrangements under

Under these circumstances, the price signals facing consumers choosing between

different payment instruments would continue to encourage the use of credit cards,

a relatively costly instrument, over less costly alternatives that provide similar

transactional benefits. Merchants would continue to face the cost burden in the

first instance. While individual merchants accept credit cards as part of a strategy

of winning sales from, or not losing sales to, competitors, no convincing evidence

has been provided – in Australia or elsewhere – that merchants as a whole gain a

permanent increase in sales by accepting credit cards to offset the higher costs. As

a consequence, average costs in the payments system would be higher and the

resources that could be directed into other productive uses would be reduced. The

Australian community would continue to pay a higher cost for its retail payments

system than is necessary.

The consequences of these inefficient price signals for total payments system costs

are substantial. As an illustration, Table 3 shows the costs of providing credit and

debit card payment services under two different growth scenarios over the next

five years. Under Scenario I, growth of credit and debit card usage is assumed to

continue at the same rates as the past five calendar years, when the number of

credit card transactions grew by 24 per cent per annum and the number of debit

card transactions by 12 per cent per annum. Under Scenario II, growth in both

payment instruments is assumed to be 18 per cent per annum, the average growth

in these two instruments combined over the past five years. If current trends were

to continue (Scenario I), the cost of providing the card payment system would be

14

around $1 billion per annum higher after five years than would be the case if

growth were more evenly shared between credit and debit cards (Scenario II).

In the absence of regulatory action by the Reserve Bank, the costs of providing

credit card services in Australia would continue to be borne by:

(i) credit cardholders who use the revolving line of credit;

(ii) merchants that accept credit cards for payment; and

(iii) the community as a whole, including consumers who do not use credit

cards.

Credit cardholders who do not settle their credit card account in full by the due

date generally pay interest rates significantly above rates on other forms of lending.

Credit card lending is unsecured and thus riskier than other types of personal

credit provided by financial institutions. Nonetheless, interest rates on credit card

lending are on average around three percentage points above the rates for other

forms of unsecured personal lending (Figure 3) and are not as responsive to changes

in funding costs as other retail interest rates (Table 4). In recent interest rate cycles

in Australia, financial institutions have passed almost the full amount of official

interest rate increases on to credit card interest rates, but only around one-half of

official interest rate reductions.

The community also bears the costs of providing credit card services through higher

prices for goods and services. In the first instance, the burden falls on merchants

that accept credit cards, particularly smaller merchants. As noted, merchant service

a Reserve Bank of Australia and Australian Competition and Consumer Commission (2000).

15

percentage point change

* Measured from peak to trough/trough to peak in the relevant interest rates.

a Midpoint rate of major banks.

b Banks’ standard variable housing loan rate; average rate of large lenders.

0

5

10

15

20

0

5

10

15

20

% %

1990 1992 1994 1996 1998 2000 2002

Introduction of annual

fees August 1993

Credit cards

Fixed unsecured

Fixed secured

Cash rate

16

fees on credit cards average 1.8 per cent of the value of each credit card transaction

and can be up to four per cent for smaller merchants. The floor on merchant service

fees is determined by interchange fees, which average 0.95 per cent per transaction.

After paying these 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. As discussed in the

Consultation Document, there is a range of evidence to suggest that, if credit card

scheme restrictions were to remain in place, competition in the credit card acquiring

market would be less effective than it might be. This evidence includes the level of

margins in credit card acquiring (around 67 per cent on information provided to

the Joint Study); the proportion of merchant service fees retained by acquirers in

Australia (around 50 per cent) compared with acquirers in the United States and

Europe (around 20 per cent); and the unwillingness of acquirers in Australia to

offer a flat fee for acquiring services in line with the nature of costs incurred by

acquirers.

In the absence of regulatory action by the Reserve Bank, merchants would continue

to pay a higher price for credit card acquiring services than if more competitive

conditions prevailed. They would also be prevented by credit card scheme

restrictions from passing merchant service fees onto customers who choose to

use credit cards. Merchants would continue to face an “all or nothing” choice –

accept credit cards and absorb the merchant service fees into their overall cost

structure, or refuse to accept credit cards at all. Their ability to resist credit cards

would be increasingly eroded as consumers responded to current price incentives

by increasing the take-up of credit cards and demanding to make more and more

use of them. Merchants would have only limited negotiating power to put pressure

on merchant service fees and, indirectly, interchange fees.

In these circumstances, the community as a whole, not just those who use credit

cards, would continue to bear the costs of providing credit card services, in the

form of higher prices for goods and services. This burden 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 impact on the general level of prices is likely to be significant. Merchant

service fees on credit cards currently cost merchants around $1.5 billion a year.

Unless merchants as a whole gain a permanent increase in sales or other benefits

from accepting credit cards, this cost is passed into price levels, depending on

supply and demand conditions in each market.

17

If credit card scheme restrictions were to remain largely unchanged, the main

beneficiaries of the arrangements would continue to be:

(i) credit card transactors who settle their credit card account in full each

month; and

(ii) credit card scheme members and the schemes themselves.

Credit card transactors make only a very small contribution to the revenues earned

by credit card issuers (Table 5). Transactors pay, at most, an annual fee to hold a

credit card but receive interest-free credit and may be eligible for loyalty points

which accrue in proportion to the value spent on their credit card. Around onequarter

of credit card balances outstanding do not attract interest. Based on

information provided to the Joint Study by card scheme members, revenues received

from transactors from annual fees fall short of the cost of providing the interest-free

period and loyalty points by around $90 million a year. That is, transactors are

subsidised by this amount each year.

A continuation of current price incentives would be expected to increase the size

of the transfer from the community to credit card scheme members. 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

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.

Source: Reserve Bank of Australia (2001).

18

financial institutions which are both significant card issuers and acquirers. The

margins are particularly wide in credit card acquiring (Table 6). 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.

The designated credit card schemes would also continue to benefit from current

arrangements. MasterCard and Visa earn revenue from credit card activities in

Australia through their operational role in providing switching facilities to

participants. The schemes typically charge their members a flat fee per transaction

for processing transactions through their switch, a source of income which has

risen significantly over recent years in line with the strong growth in the number

of credit card transactions.

The Reserve Bank’s access regime and standard on merchant pricing would remove

two impediments to effective competition and improved efficiency in the Australian

payments system.

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%) (mark-up over direct costs) (67%)

Costs of loyalty programs 0.46

Source: Reserve Bank of Australia and Australian Competition and Consumer Commission (2000).

19

The access regime would remove the current barriers to entry to the designated

credit card schemes for non-financial corporations, but without compromising

the safety of the schemes. Non-financial corporations of substance would become

eligible to apply to participate in the schemes in their own right, through a financial

subsidiary that would specialise in credit card activities. Such subsidiaries would

form a new class of specialist credit card institutions, to be authorised and

prudentially supervised by APRA. Competition from such non-traditional players,

particularly those able to take advantage of scale economies in processing or

funding, would improve the range and pricing of credit card payment services to

cardholders and merchants. This is consistent with the objective of the reforms

recommended by the Financial System Inquiry that non-traditional institutions be

able to compete in payment technologies as a means of increasing competition

and lowering costs.

The standard on merchant pricing would remove a restraint on trade imposed by

MasterCard and Visa that denies merchants the freedom to set prices for customers

that promote the competitiveness of their business. The standard would ensure

that a merchant accepting a MasterCard or Visa credit card is free to charge according

to the means of payment; if it so wished, it could charge a “fee for service” for

accepting the credit cards of these schemes.

The lifting of credit card scheme restrictions on access and merchant pricing

through Reserve Bank regulatory action would benefit:

(i) credit cardholders who use the revolving line of credit;

(ii) merchants that accept credit cards for payment; and

(iii) the community as a whole, including consumers who do not use credit

cards.

Cardholders who use the revolving line of credit would benefit from stronger

competitive pressure on credit card interest rates. As with the market for residential

mortgages in Australia in the 1990s, when the entry of specialist mortgage

originators pushed spreads between the standard mortgage rate and the cash rate

from four to below two percentage points, new entrants would provide scope for

greater competition in credit card issuing.

Merchants, and ultimately the community, would benefit from the participation

of specialist credit card acquirers with new skills and efficiencies to bring to the

designated credit card schemes. The credit card acquiring market, as noted above,

is one in which more effective competition is needed to put pressure on merchant

20

service fees and improve efficiency. So-called “net issuer” or “balanced portfolio”

rules in MasterCard and Visa prohibit participants acting only as an acquirer, while

the MasterCard and Bankcard schemes have financial penalties for participants whose

activities are more heavily weighted towards acquiring than issuing. The access

regime precludes any “net issuer” or “balanced portfolio” rules and associated

financial penalties or loadings.

Freedom for merchants to charge according to the means of payment would

introduce normal market disciplines into negotiations between merchants and

acquirers over merchant service fees, and eliminate the “all or nothing” choice

currently facing merchants deciding whether to accept credit cards. In principle,

the higher are merchant service fees levied by an acquirer, the more likely is the

merchant to pass the fees onto credit cardholders. Some merchants that had

previously refused to accept credit cards because of their costs might decide to do

so when they can pass these costs onto credit cardholders. A larger network of

merchants accepting credit cards would be of benefit to all credit cardholders.

Smaller merchants paying the highest merchant service fees would have a better

negotiating position and would benefit, more generally, from greater competition

in the credit card acquiring market.

If overseas experience is a guide, the removal of scheme restrictions on merchant

pricing 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 service”

for accepting credit cards, or may be under strong competitive pressure not to do

so. To the extent that merchants do charge, however, consumers choosing between

different payment instruments would face price signals that were more reflective

of the costs of providing these instruments; the higher costs of credit cards would

not need to be built into the overall cost structure of these merchants so consumers

using less costly payment instruments would gain from a lowering of prices. Overall,

the community would benefit from more efficient price signals.

The Reserve Bank’s regulatory actions, by promoting competition and efficiency,

would be likely, over time, to reduce the size of the transfer from the community

to financial institutions from credit card usage. This would have an impact on:

(i) credit card schemes and their members; and

(ii) credit cardholders.

Incumbents in the designated credit card schemes would face greater competition

in both credit card issuing and acquiring, putting pressure on profit margins. If

growth in the number of credit card transactions were to slow as consumers

21

switched to other payment instruments in response to more efficient price signals,

the profit projections of incumbents would need to be scaled back. The credit card

schemes themselves would expect to experience a slowing in the growth of revenue

from processing fees for the same reason.

The force of competition would determine how individual card issuers respond

in pricing their credit card services to credit cardholders. If merchants were to

charge a “fee for service” for accepting credit cards, cardholders using their credit

cards at these merchants would face more of the resource costs of providing credit

card payment services. They would, of course, have the option of avoiding those

costs by switching to lower cost payment instruments.

Over time, the Reserve Bank’s regulatory actions would also inject greater market

discipline into the setting of interchange fees in the designated credit card schemes.

The participation of specialist credit card acquirers would give merchants a stronger

and more independent voice in the fee-setting process, while the freedom of

merchants to charge according to the means of payment would strengthen the

balancing forces on collective interchange fee setting. Issuers in a scheme seeking

to increase interchange fees would be forced to reconsider the level of these fees if

merchants passed the resulting higher merchant service fees onto cardholders,

thereby discouraging credit card usage.

The time-frame for achieving greater market discipline on interchange fees is,

however, uncertain. What is required is a credible threat of entry to the acquiring

market by one or more non-traditional participants of substance, and effective

pressure on merchant service fees from merchant freedom to charge according to

the means of payment. Until such requirements are met, the collective fee-setting

process in each of the designated credit card schemes would continue to be

dominated by the four major banks, the main suppliers of credit card services and

most other payment instruments in Australia, and there would be no assurance

that interchange fees were being set at an efficient level.

The Reserve Bank’s standard on interchange fees would provide objectivity and

transparency to the process by which interchange fees are collectively set in the

designated credit card schemes. By requiring that interchange fees meet a costbased

benchmark, based on credit card payment services that are principally of

benefit to merchants, the standard would ensure that merchants, and the

community as a whole, did not bear credit card costs that arise out of the provision

of specific credit card services to cardholders.

22

The outcomes of the standard on interchange fees would be determined by the

cost calculations to be carried out by participants in each of the designated credit

card schemes. On the basis of the most recent costs provided to the Reserve Bank

by each of the four major banks, the standard would be likely to result in a

significant reduction in the average of interchange fees in Australia from the current

level of around 0.95 per cent of the value of each credit card transaction. Since

interchange fees set a floor for merchant service fees, the reduction in interchange

Competition would be expected to ensure that these lower fees were, in turn, passed

through to the final prices of goods and services.

The Reserve Bank’s standard on interchange fees would reinforce the impact of

regulatory action on access and merchant pricing in improving competition and

efficiency in the Australian payments system. Additional to the benefits accruing

under option (ii), the parties benefiting from the standard on interchange fees

would be:

(i) merchants that accept credit cards for payment; and

(ii) the community as a whole, including consumers who do not use credit

cards.

Merchant service fees on credit cards cost merchants around $1.5 billion a year.

Regulatory actions under option (iii) would strengthen competitive pressure on

these fees and reduce average costs for merchants: each 0.1 percentage point

reduction in merchant service fees would involve a reduction of around

$100 million in the size of the transfer from the community to financial institutions.

To the extent that merchants avail themselves of their freedom to charge a “fee for

service” for accepting credit cards, the costs of accepting credit cards would no

longer be reflected in the prices of goods and services paid by all consumers.

By requiring that the designated credit card schemes publish their interchange

fees, the standard would improve transparency in the fee-setting process and ensure

that merchants, and the community as a whole, know the costs that are being

passed to them through interchange fees. Identifying the specific cost categories

that make up the cost-based benchmark would also give card scheme members

and merchants an incentive to address these costs.

Additional to the impact of option (ii), the parties bearing the impact of the

standard on interchange fees would be:

23

(i) credit card schemes and their members; and

(ii) credit cardholders.

A significant reduction in average interchange fees would mean a reduction in

interchange fee revenues for all credit card issuers. Revenues from this source

account for about one-third of revenues from credit card issuing. There is no reason

to expect that the reduction in interchange fee revenues would fall

disproportionately on small and efficient credit card issuers, but high-cost issuers

might find the reduction difficult to manage. The credit card schemes would expect

to experience a slowing in the growth of revenue from processing fees if the Reserve

Bank’s regulatory actions, taken together, led consumers to switch to lower-cost

payment instruments.

It would be a matter for individual card issuers, in competition with other issuers,

to determine how they would respond to lower interchange fee revenues. Current

levels of profitability are high and some issuers might absorb some or all of the

reduction in revenues. Other issuers might want to wind back the subsidies received

by credit card transactors by moving in the direction of the “user pays” approach

they take in pricing other payment instruments that they provide. In contrast to

some other countries where transaction fees and charges for payment instruments

are rare, Australian consumers typically pay for their payment services. Financial

$b, 2001

standards on interchange fees

and on merchant pricing,

and from access regime

standard on merchant

pricing and access regime

access regime; upward

pressure from standard on

interchange fees

24

institutions have levied fees on cheque and debit card (EFTPOS) transactions for

some years, and the fees are increasingly related to the costs of providing these

services.

The expected impact of the Reserve Bank’s regulatory actions, taken together, on

the revenues earned by financial institutions from credit card activities is

summarised in Table 7.

Throughout the reform process, the Reserve Bank has attached high priority to

consultations with interested parties.

The Joint Study published in October 2000 generated considerable comment from

all sections of the community, including the credit card schemes, financial

institutions, merchants and consumer representatives. In the six-month period

before the designation of the three credit card schemes in April 2001, the Reserve

Bank received 22 written submissions containing a wide range of views on the

findings of the Joint Study and recommendations both for and against regulatory

action.

Following the designation, the Reserve Bank received a further 45 written

submissions over the remainder of 2001. It considered all of the material provided

and held numerous meetings with organisations which had made submissions to

discuss their comments in detail. This consultation process culminated in the

publication of the Consultation Document in December 2001. The Consultation

Document reviewed the main regulations of the four party credit card schemes

from the public interest viewpoint, taking into account the issues raised in the

submissions. It provided extensive discussion of the purpose and effect of the

Reserve Bank’s proposed reform measures in promoting efficiency and competition

in the Australian payments system. At the same time, the Reserve Bank published a

commissioned report on the operations of credit card schemes from an international

expert in network economics, as well as all of the prior public submissions it had

received.

submissions from interested parties on its proposed reform of credit card schemes,

by a date specified to be 15 March 2002. Submissions were received by that deadline

from 28 organisations and a number of members of the public. The Reserve Bank

has considered all of those submissions in finalising its reform measures. Comments

and other material were also received after the submission deadline, which the

Reserve Bank has also considered. A list of organisations that provided submissions