Regulation of multilateral interchange fees MIF : An experiment with an uncertain outcome!

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1 Regulation of multilateral interchange fees MIF : An experiment with an uncertain outcome! Comments of the Sparda banks on the proposal for a regulation on interchange fees for card-based payment transactions I. MIF - what does this mean? II. III. What is the impact of a legally imposed reduction in interchange fees? What is the right way forward? IV. Comments on selected provisions from the general part of the regulation (part II of the proposed regulation) Appendix: Why is the European Commission taking action? Recitals and comments from the perspective of Sparda banks. 1 / 14

2 On 24 July 2013, the EU Commission adopted the proposal for a regulation on interchange fees for card-based payment transactions, which was submitted to the EU Council and the European Parliament. The regulation consists of two key parts: The first part in particular proposes an appropriate cap on multilateral interchange fees for card transactions ( MIFs ) set at - 0,2% of the transaction value for debit card payments, - 0, 3% of the transaction value for credit card payments. This cap will apply to cross border transactions two months after the adoption of the regulation. Following a further transition period of 22 months, the cap will also apply to domestic card payments. The second part of the proposal contains general provisions for all types of card transactions and card-based payment transactions. (See chapter IV) I. MIF - what does this mean? The most commonly used credit card arrangement in the European Union is the 4- party scheme. The term stems from the four parties involved in each payment transaction: The cardholder, retailer, cardholder s bank and the retailer s bank. Particular examples of credit card companies are MasterCard and Visa as well as Maestro and VPAY on the debit card side. With the 4-party scheme, each card-based payment transaction means a fee is paid by the merchant s bank to the customer s issuing bank. These transaction fees are known as Multilateral Interchange Fees (MIF). Generally, a MIF is seen as compensation for the advance distribution costs incurred by the card issuer. Without a sufficient number of cardholders, there would be no relevant basis for issuing cards, making investments into payment processes unviable. Regarding daily card transactions, the payment guarantee issued by the cardholder s bank for each authorisation is of even greater importance for the retailers. 2 / 14

3 The MIF is also of great importance as it provides retailers with binding longterm transaction and investment security. Essentially it is due to MIF charges that in the last decades card-based payment systems have been adopted by retailers and consumers worldwide as a safe and convenient payment method! II. What is the impact of a legally imposed lowering of interchange fees? 1. Impact of the cost and gains for banks For the customer s bank (the so-called issuer ) interchange fees constitute a significant revenue block in the card-based payment business. Sparda banks earn a large part of their revenue from MIF payments. From the merchant s bank (the acquirer ) perspective, MIFs are a cost factor. A statutory reduction in interchange fees would therefore have completely different consequences for issuing and acquiring banks. Whilst from the acquirer s side margins would increase, there would be a reduction in revenue for issuers. 3 / 14

4 In many cases however, banks are simultaneously acquirers as well as issuers, as they have corporate and also private clients; in the card payment business these banks are represented on both sides of the market so that costs on the issuer side could potentially be compensated through the revenue generated on the acquirer side. This is not the case for the Sparda banks: They have decided not to engage in corporate client business and are exclusively a service provider for private consumers. This means that in the card payment business they are only an issuing bank. The full burden of any MIFreduction will therefore have to be shouldered without any corporate client business to compensate incurred costs! 2. Consequences for consumers and the economy as a whole How will the above mentioned impact of a statutory cap on interchange fees affect upon the second round? If lower MIF-prices are set then it can be assumed that the cardholders banks are negatively affected, i.e. those that primarily generate issuing revenue from card payments and will have to compensate their loss of income through adjustments in other areas. In case the affected bank does not steer away from this business area, the loss of income can only be counteracted if the issuing bank raises card fees in other areas (e.g. annual cardholder fees or charges for card losses and 4 / 14

5 cancellations). The argument by the EU Commission that lowering transactions costs will ultimately lead to an increase in card payments traffic and therefore constitute a comparable compensation for the loss of earnings can only hold true if the individual payment transaction is profitable. This is however not the case if the transaction value is capped at 0,2% for debit cards and 0,3% for credit cards. For card issuing banks, these MIF-values will definitely not result in a positive gain per transaction. How lower MIFs will affect all parties who face a cost reduction in the first round is not yet foreseeable. The overall impact is linked to the respective market positions and subsequent ability to force price movements. As initially there will be cost reductions for the acquirer, in theory it could be possible that merchants request their banks to pass on a share of the cost reduction. The result of these negotiations will set the level of sharing options possible between retailers and their customers. As already has been proven in other countries in which MIFs have been capped, it is highly likely that the cost savings made by the acquirer banks will only to a (small) extent be passed down to the merchants. It might be possible that large retail chains in particular will be successful in this, small retailers however, only marginally or not at all. 5 / 14

6 And: Even if the merchant s bank were to fully pass on the advantage to retail and not keep any of the profit, this would not produce any tangible benefits for consumers: For example, if the interchange fee would be lowered by 100 base points, then in an average transaction, in Germany this is currently around 65 - a saving of around 65 cents, would be made. This profit margin is barely feasible and in reality will most likely be swallowed through other transaction costs (such as price variations between retailers, travel costs, product choice). Limiting interchange fees therefore leads to a margin increase for retail banks and large retailers. Consumers only benefit in a very small way and potentially face higher cardholder charges. The macroeconomic effects however must not be overlooked: Should the margins for the card issuers fall below a certain level, then investment in card-based payment transactions will diminish. Regulation of interchange fees will direct investment towards rationalisation efforts, meaning the investment for actual payment innovation will diminish, resulting in a loss of much needed new developments. This would result in welfare losses, for example due to new payment options not being realised. Maintaining a high percentage of cash in the economy also has a detrimental macroeconomic effect on general welfare and the economy: This will not limit cash transactions. From a fiscal policy point of view or in the fight against money laundering, this cannot be a desired effect. From the Sparda banks perspective it is therefore essential, that as far as MIFs can even be regulated, they should at least also contain a fixed component in order to maintain an economically viable calculation for individual transactions for card-based payments in Germany. 6 / 14

7 III. What is the right way forward? The European Commission sees setting a statutory limit on interchange fees as a step towards creating equal conditions for competition. The differing MIFs in the respective member states are seen as evidence of market fragmentation. Neither the explanatory memorandum to the proposed regulation or the accompanying regulatory impact assessment takes into account that these observations can also be interpreted in completely different ways. The counter-argument therefore is: The market for card payments is for the most part a domestic market. Differing interchange fees are not a sign of market fragmentation rather an expression of varying domestic preconditions and market structure, such as in terms of payment quantity structures (e.g. given the different measures of concentration in the banking sector) and varying market maturity, whereby MIF fees in markets with low card presence are often higher so as to encourage the spread of card payments. The legal cap for interchange fees will not lead to a levelling out of competition conditions rather it will constitute a significant interference into established market processes and force national systems into new constellations. 7 / 14

8 The outcome of this adjustment process is uncertain. Looking at the arguments, it could be assumed that there is a bias against card payment systems due to anti-trust cases. However these remain essential. This means that there is only one way to move forward in a constructive manner: Before widening the scope for price regulation on domestic card payments, law makers must uphold their obligation to conduct a much more thorough review in order to avoid risking irreparable and far-reaching economic damage. Questions that must be asked are for example: - How does regulated pricing for card payments impact upon the willingness of business to invest in card payment innovation? - Do regulated prices lead to a loss of importance for card payments to the advantage of cash payments? - How are the welfare gains and losses distributed between those involved and is this distribution justifiable? - What is the impact of regulated pricing upon the market structures for card payments and the banking system as a whole? Will small and medium sized business models suffer damage which can lead to unwanted market concentration? The answers to these questions will be interesting. 8 / 14

9 Comments on selected provisions from the general part of the regulation (part II of the proposed regulation) 1. Retail surcharges on card payments: Surcharging Surcharging allows retailers to demand a fee from the customer, to offer a reduction or to otherwise encourage the use of certain payment methods that are most efficient (for the retailer). Current applicable EU rules gave member states the option whether to allow such control practices and are banned in Germany. (Even if foreign card payments of German consumers are subject to such surcharges) In the future, surcharges will be banned for all card payment systems subject to the MIF regulation in all EU countries. For payments with other card schemes, in particular the 3-party schemes such as American Express or Diners, retailers will still be able to use such control practices. Correlating fees however will be capped at the level of actual costs incurred by the payment recipient. Through this, the EU Commission hopes to steer away from relatively expensive, unregulated schemes. Whether this is realistic remains an assumption, for the time being. In any case there are clear inconsistencies in the regulation of 3- and 4-party schemes. To the Sparda banks, this seems somewhat to be an experiment with an uncertain outcome. 2. Separation of card system and processing offers Article 7 of the draft regulation, sets out that companies offering card payment systems and companies who technically process card payment transactions must be organisationally separated from each other. 9 / 14

10 The separation of both offers would initially result in huge adjustment costs on both sides of the card payment system through the organisational and legal separation into independent company entities. At the same time, it is the hope of the EU Commission that this will encourage the establishment of new processing competitors. At first glance, the resulting competitive impetus is a welcome effect from the point of view of card issuing banks however it also runs the risk that there is no adequate market offer aside from the established processing providers. In the end, this could mean that the immense administrative burden will be left to system users i.e. issuers, acquirer and consumers. The question must be raised whether different methods can be used to open up the market, for example through a simple banning of the mandatory bundling of card payment systems as well as increased transparency in the price design for both services. 3. Repeal of the Honour all cards ruling The application of the honour all cards rule under article 10 of the draft regulation has been restricted so that card schemes can no longer demand merchants to accept particular cards if they accept other brands or card types of the same scheme. Unless both brand and card type are subject to the same regulated interchange fees. It is our understanding that this addition restricts the bundling prohibition of cards of the same type. It would for example be forbidden to force a merchant to accept a debit card, if that merchant had already accepted a credit card from the same card scheme. This seems useful to us as the retailer can then chose the best and most accepted credit and debit card offer. Conversely for example, a merchant could be expected to accept a premium credit card if previously a debit card from the same brand had been utilised. This would also be an acceptable interpretation of the provision, as consumers who chose relatively expensive cards with premium features want to have the guarantee that they are able to pay at all available payments points. 10 / 14

11 Appendix: Why is the European Commission taking action? Recitals and comments from the perspective of Sparda banks. The Commission sees MIFs in 4-party schemes as an obstacle to card payments in the internal market. The competition between card companies is mainly directed towards encouraging as many card issuers as possible to offer their customers the respective cards. In contrast to the usual disciplinary effect of competition on pricing, this leads to a competition between MIFs, which potentially can result in higher prices for consumers. - The majority of card issuing banks are also simultaneously retail banks. This double role means that they do not have an interest in increasing interchange fees, as higher MIFs significantly affect acceptance of cards by corporate clients. - This counteracts an assumed race in MIFs that in reality is non-existent. To the contrary: For years the average MIF-level worldwide has significantly lowered without regulatory intervention. To that extent there is even a definite disciplinary effect on price even in 4-party schemes. Merchants cannot use banking services in other member states to circumvent differences in fees as specific rules of the card providers state that the home country of the merchant is recipient of the MIF. - At first glance, a different level of interchange fees for the same services in an internal market seems contradictory. The Sparda Banks are not against a price adjustment. - MIF fees have developed according to the overall country specific situation. Countries which promote the spread of card payments have a tendency towards higher MIFs and lower charges for all other card payments. - Independent pricing leads to a set minimum charge to cover the costs of the individual card transactions. Different individual costs in various countries and banks (banking groups) subsequently lead to varying interchange fees. If prices are set in the market, then these different starting bases are taken into account in the price negotiations. 11 / 14

12 - Statutory pricing cannot be controlled without unwanted side effects and circumvention attempts: If statutory MIFs do not cover the cost of an individual transaction then either the market suffers a loss of choice as providers are forced to leave the market or significant cost increases in other areas will occur resulting in an unfair crosssubsidy. - Set pricing policy for interchange fees will also have structural effects on the payments market: In order to achieve the scale effect, there is a forced shift towards larger enterprise sizes in order to meet the target margins. Only providers with extremely cost and process effective high volume transactions will be able to generate sufficient revenue. This promotes the creation of an oligopoly on the provider s side. The MIF flows into the merchant s calculations and potentially therefore creates a higher retail price as a consequence even for those not paying by card. - Cash payments also incur costs, such as transportation, as well as reviewing and auditing of the cash balance according to the Bundesbank criteria. These costs are also taken into account when calculating the price offer. Therefore the argument of the EU Commission is also applicable in reverse: All customers who always pay by card, then also carry the costs of cash administration. - A further example highlights the difficulties with this argument: Every supermarket will take into account the cost of providing car parks (purchase or lease of property, facilities management, municipal fees, taxes, etc.) when calculating the price offer. In this case every customer who would travel by bike or public transport would help shoulder these costs. 12 / 14

13 Interchanges fees lead to a restriction in choice of payment service providers and limited innovation activities. - Hardly any market in the European Union is as innovative as that of the payment service providers. A number of products and service innovation projects are currently being established in the market, further ones are being developed. This diversity of systems and offers is an advantage for consumers and retailers. - There is no evidence for restricted innovation due to interchange fees. - In addition: Innovation in market economies is primarily a result of strong competition. This is not compatible with legally capped prices. 13 / 14

14 About the Sparda banks group Sparda banks, the business community that makes banking business fair and easy Issue 4 October 2013 The region is our market. Therefore we stand for: Performance and prices should not be standardised or legally regulated. We accept the competition with providers from throughout the EU single market, however demand fair competitive conditions. Together with our members, we do not would to be liable for the risks taken by others, whether in Germany or in Europe. This also applies to our cooperative system for investment and institution safeguards. Our business model and products are straightforward, low in risk and largely independent of the capital market. Therefore we stand for: Straightforward business models require straightforward regulation. Small and medium-sized banks should not be disproportionately burdened. Low-risk banking business does not need to be subjected to the same demands as speculative capital market actors. In Germany, the Sparda banks set the benchmark for customer satisfaction. Therefore we stand for: A relationship of trust with the customer is the basis for practical consumer protection. For us the conversation with customers is the most important contact. Formal requirements, documentation- and monitoring obligations are not allowed to overshadow the relationship with the customer. We live the ideas and values of the cooperative in the purest form. Therefore we stand for: The cooperative sector must be supported and maintained as a stable pillar of a diversified banking structure. Banking regulation should not hinder or even render the operation of a bank as a cooperative impossible. The cooperative associations of banks should not be discriminated against in contrast to corporate structures. The Sparda banks group consists of 12 economically and legally independent institutions and several service companies such as the Sparda data processing eg and Sparda Consult for Project and Innovation Management GmbH. With over 3.41 million members and approximately four million customers the Sparda banks are among the important retail banks in Germany. The Sparda banks, as cooperative banks, are members of the Federal Association of German Cooperative Banks (BVR) and part of the cooperative finance group. 14 / 14