Glenn Stevens: Public policy and the payments system
Text by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, of the Third Annual
Ian Little Memorial Lecture, Melbourne, 25 March 2009.
* * *
Introduction
It is a great pleasure to be here in Melbourne to deliver the Ian Little Memorial Lecture. I
worked with Ian when we were both young recruits in the Research Department of the
Reserve Bank in the early 1980s. I remember an easygoing young man with a cheerful
disposition, and a mop of curly dark hair. Even then, Ian was a clear thinker with a strong
commitment to good public policy. So it was not really surprising that, having left the Reserve
Bank in the late 1980s and succeeded in the private sector, he returned to public service in
the Victorian Department of Treasury. In that role, as many of you here know better than I do,
he shone.
I would occasionally run into Ian at conferences and he would always impress on me, a
macroeconomist working in the central bank, the need to acknowledge the importance of
microeconomic policy reforms in bettering economic performance. It is a simple, but
important, point. While macroeconomic policies are to the fore right now around the world, as
governments and central banks seek to foster recovery from recession, in the long term our
living standards depend more on innovation and productivity, and less on the manipulation of
interest rates or aggregate spending decisions by governments, than common discussion
often admits. Real prosperity depends critically on the supply side of the economy - the
realm of microeconomic policies.
It is in that spirit that I wish to speak today about something that I have not addressed in
public before, namely, the payments system. Although the Reserve Bank is best known for
its macroeconomic policy responsibilities, it has, in fact, an important microeconomic
responsibility, namely, the competitiveness and efficiency of the payments system, including
at the retail level. This obligation was given to the Payments System Board of the Reserve
Bank, as a result of the Wallis Committee process in the mid 1990s - hence, my topic this
evening.
Motivation
We might begin by asking: why is an efficient payments system important?
The answer is that the payments system facilitates all economic and financial activity,
whether it be the day-to-day payments that you and I make, payments between businesses
or transactions in financial assets. There are around 18 million transactions in Australia every
day, with a value of around $230 billion. With so many payments, even relatively small
inefficiencies can potentially have significant implications for the costs of the payments
system. Part of the Reserve Bank's job, therefore, is to promote efficient arrangements in the
payment system in the interest of the broader economy. Earlier reforms to the high-value
payment system improved efficiency and safety, but in the retail payment area, progress has
been slower.
In fulfilling its responsibilities over the past 10 years, the Reserve Bank has in some fairly
high-profile instances ultimately resorted to regulation. This has not been because we have
had a strong predilection for regulatory solutions. On the contrary, the Reserve Bank has
usually first sought to achieve improvements in competition and efficiency without direct
regulation. In particular, it has sought to encourage the players in the payments space to
identify potential improvements and to undertake reforms to achieve these. But such
industry-led reforms have sometimes been difficult to achieve, and so the Reserve Bank has
ultimately been required to take a stronger role, including by regulating.
I want to examine why this is the case, both at a general level and by reference to a recent
example. These observations are framed by the particular challenges the Reserve Bank has
faced in promoting competition and efficiency in the payments system, but the conclusions
apply to a number of other areas where regulators are working to spur improvements in
efficiency and productivity.
Co-operation and competition in networks
In payment systems, as with other networks, a certain amount of co-operation between
participants is needed to ensure that the system provides benefits to users. For example,
when you or I purchase something at a retailer, it should not matter with whom the retailer
banks, or with whom you or I bank. We expect to be able to rely on the banking system to
transfer money from us to the retailer. We expect that, when we pull out our debit or credit
card to pay, it just works. That requires a detailed set of co-operative arrangements between
financial institutions to accommodate payments between each other's customers.
These same institutions are also competing with each other, however, to attract customers. A
common way to compete is to offer products or features not offered by one's competitors.
But if the ability to offer that new product relies on competitors making changes to their
systems, innovation may be stymied. Why would other banks be willing to incur the costs of
developing the relevant systems in order to help customers of their competitors?
The tension between these two separate dynamics - the need for co-operation and the
impulse to competition - means that the industry may have difficulty taking decisions in the
interests of the system as a whole, and of the community more broadly. In such
circumstances, someone - an industry group or a regulator - may need to play a co
ordinating role, to encourage improvements in the common infrastructure that benefit all,
while still allowing competitive forces between the banks to ensure that the new products are
priced competitively and packaged to meet customers' needs.
Of course, these issues are neither new nor unique to the payments industry. It is well
accepted in the economic literature that in industries that rely on networks of infrastructure
(so-called "network industries") there is an incentive to co-operate in order to gain
efficiencies, but a socially optimal level of co-operation might not be achieved.
One illustration of this point which has been cited in the network literature is the development
of the rail network in the United States in the 19th century.1
The early US railway system consisted of a large number of individual links between pairs of
destinations, often on different track gauges and designs. There was a clear public (and
private) benefit in linking these "networks" to allow goods or passengers to cross efficiently
from one railway to another. But, nonetheless, railways were often designed to be
incompatible, so as to prevent competitors from siphoning off traffic.
Eventually, the commercial logic for some degree of co-operation was sufficient to ensure
that standardisation occurred and this brought with it large productivity gains. For instance, in
the space of a decade, the time for shipment of goods by rail from Philadelphia to Chicago
was reduced from nine weeks to three days.2 Despite these pay offs, standardisation was
still not complete. In fact, the only way railways could reach an optimal level of
standardisation was horizontal integration - merging competing railways.
While all this sounds a million miles away from Australia's payments system in the 21st
century, the parallels are quite strong. For example, like the linking of the railways, the
realisation that a single, interconnected EFTPOS system was more valuable than a number
of individual EFTPOS systems that could not talk to one another drove co operation and
standardisation quite early in the development of that system. But despite the benefits that
brought, co operation, standardisation and innovation in Australia's EFTPOS system have
not progressed as far as is desirable. The EFTPOS system has essentially remained
unchanged since its establishment in the 1980s. The fact that the system is built on bilateral
links between all the major participants means that there is no one standardised
communications protocol between the participants. Furthermore, co operative efforts to
innovate or upgrade the system are complicated because they require all bilateral
relationships to be renegotiated. This is, in fact, a difficulty with many of Australia's payment
systems - they are based on bilateral links, with no established mechanism to foster
improvements and expansion in the network.
So left to their own devices, networks may stop short of an efficient level of co-operation.
Incomplete standardisation may result, and innovation or movement from one standard to a
superior one may be difficult because of co-ordination problems, even where the benefits to
society outweigh the costs.
The literature points to several reasons for this potential outcome, some of which are evident
from the example I have already given.
The first is the classic economic externality. Firms within the network may be concerned that
if they agree a common standard with a competitor, that competitor may be able to capture
some of the benefits of moving to that standard. Why would I pay all the cost of converting
my railway line to a gauge that can connect with another railway, when my competitor will
gain as much of my rail traffic as I will of his? The implication is that competitors in a network
might not individually make decisions that are optimal for the network as a whole.
The second is the ineffectiveness of voluntary strategies for achieving co-operation in a
network industry owned by competing firms. Establishment of industry bodies to agree
standards is a common approach, but the success of these bodies has been mixed.
Agreement tends to be delayed where there are vested interests and, in some cases, non
standardisation is used as a barrier to entry by competitors.3
Third, there is often a tendency towards "excess inertia" in standards.4 Problems with
coordinating the movement from an old standard to a superior standard (such as the movement
to new system architecture in a payment system) may mean that the movement does not
occur, or occurs very slowly, even where the benefits to society outweigh the costs of
switching. These co ordination problems may be caused by an uneven distribution of the
costs and benefits of switching standards, or by uncertainty regarding the movement of rival
firms to the new standard.5
A recent Australian example
From first principles, therefore, we might expect that achieving agreement among Australian
financial institutions on development of the payments system might not be easy. So it has
proved. There are a number of examples of this, but a recent one is the efforts by the
industry at reform of the ATM system.
As you may be aware, there have recently been some changes to the way ATM transactions
at machines not owned by your bank are priced and paid for. Instead of paying a relatively
obscure "foreign ATM fee", that was charged to your bank account at the end of the month,
people are now presented with the cost of the transaction in real time. These changes will, in
our view, allow competitive forces to come into play in a way that was previously impossible.
But it is the process of achieving the reforms, more than the likely benefits, on which I want
to focus this evening. In particular, it required changes in the bilateral links between all the
major players in the system. In this sense, the problems were akin to those of the US railway
system - how do we get all the competitors to agree to change their bilateral links in a
standardised way?
Work by the industry on the reforms started as long ago as 2001. While some progress was
made over the next few years, participants ultimately could not agree and asked the
Payments System Board for guidance on the way forward. Finally, after much cajoling by the
Reserve Bank, the new arrangements were implemented earlier this month - some eight
years after discussions on the issue commenced. Ironically, the package implemented differs
very little from the proposal put forward by the industry group itself in 2004, which was
subsequently abandoned owing to irreconcilable differences between some of the parties.
Moreover, despite a firm desire by the industry to implement the new arrangements without
Reserve Bank intervention, the industry ultimately asked the Reserve Bank to use its powers
to help finalise the process.
This is not a unique example. Reforms to most of Australia's payment systems including
cheques, direct entry and EFTPOS faced similar challenges. As we have seen, this is not
altogether surprising given the network nature of the payments system and the number of
players which must co-operate, but also compete.
The bilateral architecture that I have already mentioned is also a difficulty. Every large bank
has an agreement with every other large bank about how to handle payments from one
another's customers. The more banks there are, the more agreements are necessary and
the more complicated the system becomes. To use the railway line analogy, the more
customised tracks are built, the more difficult the task of ultimately converting all tracks to a
standard gauge.
This has two implications. First, while these bilateral agreements can be helpful in getting a
system started initially, and may subsequently work well for those already in the system,
potential new entrants face the prospect of negotiating numerous different connections. This
can act as a barrier to entry, inhibiting competition.
Second, because upgrading the network requires participants to agree, since they all must
make changes, each participant therefore can effectively veto, or at least delay, any
decisions affecting the network. Because different participants have different technology
cycles and different strategic interests, there is a high probability that some participants will
be unwilling to proceed at any given point in time. If a participant thinks a particular change
may provide another participant with a potential competitive advantage, it will probably
attempt to delay. Indeed, if one participant sees a potential competitive advantage in a
change, it is almost guaranteed that another will see a disadvantage and, therefore, seek to
block the change. This results in a significant co ordination problem for the industry.
The result is that, in the underlying architecture of the Australian payments system, very little
has changed over the past 20 or 30 years, even though technology has evolved in the
quarter of a century since the technology underlying the ATM and EFTPOS systems was first
established. So while the payments system infrastructure has served Australia well,
pressures for change are building. The network structure needs to be updated and services
to customers are starting to fall behind those available in other countries. In the past, the
Reserve Bank has identified real-time internet payments, business-to-business payments
and online payment mechanisms as examples where progress has been made overseas but
not, to date, in Australia.
The resulting co-ordination challenges were very evident in the process of reform in the ATM
system. With each of the parties having different objectives, consensus was hard to achieve.
For example, small institutions would only consider a system that allowed them to form
feefree networks among themselves - otherwise they would be at a competitive disadvantage to
the big banks with their large ATM networks. But larger institutions saw an opportunity to
obtain a competitive advantage if smaller institutions could not form larger fee-free networks.
There was also reluctance to liberalise access to the system. While improved access would
serve to increase the benefits of the system as a whole and therefore the participants
collectively, each bank tended to focus on the costs it would bear individually as well as the
competition it would face. In short, there were problems because there was no participant in
the system thinking of the benefit to the system as a whole with the power to effect change.
Now in many countries, this role is handled by a single private sector entity that manages a
system or systems. For example, the credit card schemes have a central body responsible
for governance, innovation and promotion. Their incentive is to do things that expand the
network, making its use easier and more attractive and increasing the number of participants.
They have, in effect, internalised some of the externalities inherent in the network. While the
credit card systems have had other elements that unduly limited competition in some
respects, the centralised approach is arguably superior for network innovation and growth.
That central body can determine standards and co-ordinate change. These arrangements
are also more access-friendly in that a new entrant need only establish one, standardised
connection to the system. Some private payment systems in other countries have such an
entity - for example, LINK which manages the ATM system in the United Kingdom, Interac
which manages the equivalent of the EFTPOS and ATM systems in Canada, and Paymark
which manages New Zealand's EFTPOS network. But that entity is missing in Australian
payment systems.
What role for public policy?
These considerations all suggest that there is an important potential role for public policy in
promoting change in the payments system. While the academic literature is divided generally
on the role of regulation in network industries, there seems to be support for careful
regulatory intervention in industries with competing network components where sufficient
standardisation or a move between standards cannot be achieved in a timely manner. There
also seems to be considerable sense in having an entity with responsibility to consider the
interests of the system (and society) as a whole and the power to achieve reform to that end.
Indeed, the need to have a body responsible for promoting the public interest through
competition and efficiency in the payments system was recognised by the Wallis Committee
over a decade ago. It led directly to the establishment of the Payments System Board at the
Reserve Bank and the granting of its current statutory goals and powers.
The fact that the central bank fulfils this oversight role in Australia is unusual internationally -
in many countries, issues of competition in, and efficiency of, payment systems fall to
competition authorities. But it is nevertheless common to find structures in place in network
industries to assist in promoting access and the efficient setting of standards - whether this
is a body that merely assists with co-ordination or one that has powers to enforce or perhaps
set standards. We see this in network industries in Australia, such as telecommunications,
electricity and ports, where there is frequently some sort of public body with oversight of the
network, perhaps operating in conjunction with an industry body or bodies.
Of course, such bodies should not take a decision to regulate hastily. In most cases, a
graduated approach to regulation in these areas is pursued, reflecting a reluctance to
assume that a regulatory solution is necessarily superior, or that the government would
necessarily be able to choose the best standard, particularly in a highly technical or rapidly
changing field. The typical approach of network regulators is to prefer a co operative industry
approach to standard setting, to provide some suasion where this process is unsuccessful,
but ultimately to set standards if necessary. Where intervention is required, the academic
literature suggests that we might look first of all to ensure compatibility between competing
standards - for instance, by rules governing access and interconnection between competing
networks - before setting detailed standards themselves.
So there is not a presumption that a black-letter regulatory solution will be adopted. In fact, at
the time that the current regulatory arrangements for Australia's payment systems were
established, there was an expectation that a co-regulatory model would be followed. In this
view, industry would progress reform for the most part and the Reserve Bank's powers would
be used only occasionally, as a last resort, where reform could not otherwise be achieved.
As it has turned out, however, the Reserve Bank's powers have had to be used more often
than I suspect was initially imagined. The Reserve Bank always explores ways that its
statutory goals of competition and efficiency in the payments system can be achieved without
resorting to its direct regulatory powers. But the history of the ATM reforms demonstrates
how difficult it is for pure industry-based reform to move ahead without at least some push
from a public policy body.
Possible approaches
Reflecting on that experience then, and looking to the future, the question is how best to
strike the balance and to facilitate reform most effectively. There are a few possible
approaches - each one more interventionist than the previous one.
First, the Reserve Bank could agree targets and timelines with the industry, but without any
explicit regulation or penalty for failure to meet those targets. This approach is similar to the
approach that the existing industry payments body, the Australian Payments Clearing
Association (APCA), takes with many of its projects. Provided agreement on the need for
change can be reached (no small achievement), APCA plays a co-ordinating role in
organising a project plan, providing some resources and setting timelines and targets, though
in the past these projects have tended to focus on technical issues rather than strategic
directions.
In the absence of agreement on the need for change, however, industry-based projects -
which, after all, rely on mutual agreement - tend not to proceed sufficiently quickly.
That observation leads to the second option - the possibility of the Reserve Bank using overt
regulation may be enough to forge agreement among industry participants. This is the path
that was predominantly followed in progressing reform of the ATM system, and in a number
of other reforms to the payments system. Where industry agreement on an issue was not
forthcoming, the Reserve Bank has engaged the various sides to seek a solution with the
clear possibility that it might regulate if agreement could not be reached. This approach was
essentially behind the establishment of the Payments Council in the United Kingdom, and the
development of the UK's "Faster Payments"6 - both of these initiatives were undertaken with
the knowledge that, were something not done, there would be official intervention.
While this can work, and emphasises the co ordination role that the Reserve Bank can play
in the industry, the experience with the ATM system suggests that it still may be a drawn-out
process. Individual participants with a preference for the status quo have no incentive to
push the plan along and so it relies on the Reserve Bank setting a timetable for agreement
and implementation - a timetable that is invariably argued to be "challenging".
A third, more intrusive, option is for the Reserve Bank to set explicit standards - what may be
viewed as more traditional regulation. This is the approach that was taken when dealing with
the credit card schemes, where the Reserve Bank set a number of standards dealing with
the level of interchange fees and the imposition of surcharges. This approach could,
however, also be used to achieve industry co-ordination around technical issues. For
example, the Reserve Bank could set technical standards where the industry has been
unable to agree on a common standard itself.
Such an approach may yet become relevant in Australia's electronic payments system,
especially where co-ordination problems are inhibiting innovation. As an example, some
have suggested that the Reserve Bank could play a role in the further development of the
EFTPOS system. The system was designed originally to transfer money from consumer
accounts to merchant accounts. These transfers are initiated when an EFTPOS card is
swiped through a merchant's terminal and the impact on the customer's account is
immediate. In recent years, however, there has been demand to use the system in a different
way, to send payments into consumers' accounts in real time. These demands flowed initially
from the government looking to ensure benefit payments reach recipients as quickly as
possible - for example, when providing emergency funds after a natural disaster. The
EFTPOS system at present can accommodate these sorts of payments only in a limited way.
While some participants in the industry have seen benefit in expanding the EFTPOS
message format to enable such transactions, there has been limited progress. A requirement
by the Reserve Bank that all participants in the industry be able to accept instructions
conforming to a common message standard would facilitate access by new entrants, and
thus competition. If the Reserve Bank chose to require use of an international standard, that
could also facilitate more competition from overseas providers of payment related services. A
mandate from the Reserve Bank that EFTPOS message formats must be able to support
credit transactions might likewise lay the foundation for innovation in the EFTPOS system
based on these transactions more quickly than the industry might be able to achieve by itself.
Notwithstanding its regulations with respect to card payment systems, the Reserve Bank has
in the past preferred the first two of the above options. This is particularly the case with
respect to issues relating to technical standards and system architecture, where the Reserve
Bank has on occasion raised the issues but left the industry to drive reforms. We remain
conscious of the risks that public intervention itself may be an impediment to innovation. As
we have said a number of times, our hope is that the industry will deal with these issues
itself. But we also know that if the industry fails to push ahead with improvements to the
system, Australians will be denied the full benefits of a modern retail payments system.
To a large extent, the future approach of the Payments System Board depends on the
behaviour of industry participants. If industry agreement on further reforms can be reached
relatively quickly, then the need for the Reserve Bank's co-ordinating role to be
interventionist is limited. On the other hand, if, as on some past occasions, the industry is
unable to carry forward reform and innovation by itself, the Reserve Bank would consider
making more extensive use of the tools at its disposal.
Conclusion
The economics of networks are complex, and the role of public policy is a delicate one. The
aim is to ensure, as far as we can, that the correct balance is struck between the need for
cooperation and the benefits of competition. Co-operation is required in order to ensure that the
benefits of an extensive, and reasonably standardised, network can be enjoyed by the public,
raising economic welfare. Competition is vital in the long run to make sure that costs are
minimised and the incentive to respond to changing consumer preferences maximised.
Policy has to recognise and fulfil its role in dealing with the externalities inherent in the set of
decisions made by private market participants, while also respecting and maintaining the
competitive dynamic.
We recognise that the roles of the industry participants and the regulator are mutually
interdependent. We trust that the industry does too. The Payments System Board is content
to confine itself to encouraging industry solutions and being the occasional catalyst for
agreement among the parties, where that achieves the goals the Board has been given. But
it is and must be also prepared, if needed, to use regulatory powers more forcefully. In
judging which approach is preferred, we will respond to the industry's behaviour, just as they
respond to ours.
The approach we adopt in any instance has to be tailored to the circumstances and we will
ourselves on occasion need to innovate. What will be constant is the set of statutory goals
given to the Payments System Board - controlling risk, and promoting competition and
efficiency in the payments system. The Payments System Board is committed to those
objectives and will be pragmatic, but determined, in pursuing them. We look forward to
effective engagement with the industry in the process.