I J Macfarlane: Gresham's Law of Payments
Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the AIBF Industry Forum
2005, Sydney, 23 March 2005.
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I suppose I should start by explaining why I have chosen this title for my talk today.
Gresham's Law is usually stated simply as 'the bad currency drives out the good' and it refers to a time
when all transactions used coins. If you had to buy one pound's worth of merchandise and you had
two coins - one which you knew contained one pound's worth of gold and another where some of the
gold had been shaved off - you would pass the second coin and keep the first one. In that way, most
of the transactions would take place using the inferior transaction medium and the superior one would
play a minor role. Note that this can occur only if both the inferior and superior transaction medium
were accepted at the same price, or in modern parlance, the price signals were not getting through to
the users.
Having introduced this quaint historical economic law, I would now like to put it aside for a moment
and move on to the main subject of my talk today, which is the regulation of the retail payments
system. As you are probably aware, the Payments System Board of the Reserve Bank, of which I am
the Chairman, is charged by an act of Parliament with responsibility for the efficiency, competition and
safety of the payments system. This is quite a daunting task, and has involved us in an enormous
amount of research and consultation on payments system issues, some controversy with payments
system providers and, to a lesser extent, with some payments system users.
Most of us at the Reserve Bank come from a background in economics and hence have a
predisposition in favour of free markets and a sceptical attitude towards intervention in those markets
unless there is a clearly defined economic rationale for it. After much analysis and discussion, we
came to the view some time ago that there was, in fact, an overwhelming case for regulation of some
parts of this market, and that competition, such as it was, would not lead to an optimal outcome in
terms of the public benefit. In my remarks this afternoon I would like to set out why this is so and, in
the process, I hope it will become clear why I introduced this talk by referring to Sir Thomas Gresham
and his famous law.
There are five basic ways of making a payment in the Australian retail payments system: with cash,
cheque, credit card, debit card (EFTPOS) and electronic transfer. When we looked at how these
methods of payment were evolving, we saw that credit cards were growing faster than the other
means of payment. This was initially somewhat surprising as credit card transactions are more
expensive than most other means of payment - that is, they involve a larger payment from the users
of the payments system to the providers of the payments system. In effect, what was happening was
that the most expensive way of paying was driving out the cheaper ways and, in the process, raising
the average cost of the Australian retail payments system. Why was this possible?
We concluded this was because there was an asymmetry between the price signals (and the capacity
to act on them) faced by the two classes of payments system users - the cardholders and the
merchants. For cardholders, the price signal they received was that credit card transactions were free,
or could even result in receiving a payment in the form of 'points'. Furthermore, cardholders were able
to act on this signal as they were the party that chose the method of payment at the point of sale.
Merchants, on the other hand, received a signal that the credit card was the most expensive way of
making a payment (via the merchant service fee that was paid to their bank). But merchants had no
power to influence the method of payment for the transaction - for that was in the hands of the
cardholder. Thus, the incentives in the system were designed to encourage the decision-maker to
choose the form of payment that was the most expensive from the perspective of society as a whole.
Now it could be argued that merchants could have refused to accept credit cards in the first place. But
that would have been a big decision, and the fact is that most merchants felt that they would forgo too
many sales if they had taken that path (particularly if their competitors did not). They did not feel that
they had much bargaining power vis-à-vis the credit card schemes and the banks. And until our recent
reforms, they did not have the power to 'pass on' the merchant service fee to the customer, that is,
employ the 'user pays' principle by insisting that if customers use an expensive means of payment
they should pay more than if they use a cheaper one. Merchants now have that power as a result of
our reforms, but in most cases they are reluctant to use it as the public have become accustomed to
the old system and thus often resist the transition to 'user pays'.
In short, the asymmetry in price signals is still there despite our efforts to redress the imbalance by
'empowering the merchants'. It is this asymmetry which is at the heart of the process whereby the
more expensive means of payment expands at the expense of the less expensive.
The mechanism that allows the asymmetry to be exploited is the system of fees that banks in the
payments system pay one another - commonly known as interchange fees. In the case of credit
cards, the fee is paid from the merchant's bank to the cardholder's bank on each transaction. These
fees play an important role in determining the prices charged to both merchants and cardholders for
payment services, yet they are not subject to the normal competitive forces that operate in most other
markets. To the extent that competitive forces work at all, they perversely have had two effects:
•
they have encouraged the high-interchange-fee means of payment to grow at the expense of
the low-interchange-fee one;
•
they have tended to push interchange fees up for the competing systems, not down.
In this respect, the Australian experience is not unique. There are many examples around the world
where these two effects are evident.
I would like to illustrate this process by drawing on three examples, two of which are from the United
States and the third from Australia. I am using US examples, not because examples do not exist
elsewhere, but simply because legal cases in the United States have shone the spotlight on
interchange fees more intensely than has been the case elsewhere, and because in many other
countries interchange fees remain closely guarded secrets.
Competition Between Credit Card Schemes
The first example relates to the interchange fees in the MasterCard and Visa credit card systems in
the United States, where over the past decade there have been a series of competitive increases in
these fees (Graph 1). There is an incentive for each scheme to raise its interchange fee in order to
encourage banks to issue its cards because the higher fee provides the issuing bank with more
revenue. The issuing banks in turn use the revenue to attract cardholders away from the scheme with
the lower fee by offering cardholders more attractive pricing or more 'reward points'. Once one of the
schemes raised interchange fees to give itself an advantage in attracting issuers and cardholders, the
other responded in the same way. The result has been that competition amongst the schemes has
seen fees increase from under 1.3 per cent in 1994 to 1.65 per cent today - a perverse outcome to
anyone with an economics background who expects competition to lower prices. I might add that this
is three times the average level of interchange fees in Australia following the Reserve Bank's reforms
in 2003.
Graph 1
Of course the increase in US interchange fees has to be paid for by somebody. And, in the first
instance, that somebody is the merchant, since interchange fees are built into the merchant service
fee (what the merchant's bank charges it for processing credit card transactions). Not surprisingly,
average merchant service fees have increased broadly in line with the increase in interchange fees
since the mid 1990s.
The end result is that merchants have to bear the extra costs of the competition between the credit
card schemes. But, of course, the story does not stop here. Ultimately, higher merchant costs flow
through into higher prices for the customers of those merchants. This is a cost borne by all consumers
whether they use a credit card or not.
Competition Between Debit Card Schemes
There is a similar story in the competition between two types of debit card systems in the United
States. In one system, operated mainly as regional networks, transactions are authorised by PIN (the
PIN-based systems), while in the other, operated by Visa and MasterCard, transactions are authorised
by signature (the scheme-based systems).
The interchange fee paid by the merchant's bank to issuing banks is much higher in the
schemebased systems than the PIN-based systems (Graph 2). As a result, issuing banks have been switching
to the scheme-based systems and their share of the market has increased from 45 per cent to 60 per
cent over the past decade (Graph 2). The PIN-based schemes have retaliated to some extent, and
their interchange fees have more than doubled over the decade, although they are still well below the
scheme-based systems' interchange fees. Once again, interchange fees have encouraged the growth
of the relatively expensive payments system at the expense of the lower-cost system, and forced the
lower-cost scheme to raise the price that is charged to merchants.
Graph 2
There is an interesting additional twist to this story, and it concerns the question of why the merchants
of America allowed this to happen? Why didn't they resist more strongly the inroads into their profits
caused by the expansion of the expensive system? Partly, of course, it was because they could pass
the costs on to consumers in the form of higher prices, but there was an additional factor at work. This
was the 'tie-in' arrangement imposed by Visa and MasterCard that forced any merchant accepting
their credit cards to also accept their debit cards.
By the mid 1990s, the merchants had become so upset by this rule that they took the credit card
schemes to court - in what became known as the Wal-Mart case - arguing that the rule breached
antitrust laws. In April 2003, the case was finally settled, with Visa and MasterCard agreeing to abolish the
rule, reduce the interchange fee, and pay damages of $3 billion to the merchants.
Credit and Debit Cards in Australia
This brings me back to where I started. In Australia, prior to the Bank's recent reforms, the average
interchange fee for a $100 transaction paid to a credit cardholder's bank was 95 cents. In the
Australian EFTPOS/debit card system,1 the interchange fee flows in the opposite direction and the
cardholder's bank has to pay around 20 cents per transaction to the merchant's bank (Graph 3). Given
these flows, it is clear why card issuing banks wanted to issue credit cards rather than EFTPOS cards
- they received $1.15 more for each $100 transaction.
During the mid 1990s, the Australian banks worked hard at developing reward schemes (largely
financed by their interchange fee receipts) to encourage cardholders to use credit cards. Reward
points, together with interest-free credit, meant that many cardholders were being paid 1 per cent or
more of the value of each transaction by credit card.
Not surprisingly, there was a big shift towards credit cards, with transaction numbers growing at 20 to
30 per cent for around five years, while EFTPOS growth fell to less than 10 per cent per year. As with
the US experience, a higher-cost payments system was displacing a lower-cost one, and the
community's resources devoted to making payments increased.
Graph 3
One of the longer-term aims of our reforms is to reduce the distortions in the payments system caused
by the pattern of interchange fees. If large differences in the fees in the credit card and EFTPOS
systems continue, it is hard to see why in the long run banks would continue to put resources into
promoting the EFTPOS system. This is why we think that the merchants who oppose our EFTPOS
reforms are extremely short-sighted. Without the proposed reforms, we could see a gradual withering
away of the EFTPOS system, so that the merchants would face a larger and larger proportion of their
sales taking place using the higher-cost credit card system.
Back to Gresham's Law
It is pretty obvious by now where Gresham's Law fits into my account, so I hardly need to spell it out.
Instead of the bad currency driving out the good, we have the high-cost means of payment driving out
the low-cost one. To take the most obvious example, a credit card offers the same service to a
merchant - irrevocable payment - as a debit card, yet costs the merchant a lot more. To the
cardholder, the credit card offers more - about 50 days free credit - yet it costs less, with the
cardholder often receiving payment for using it. Clearly, the second condition for Gresham's Law is
met, namely that the price signals to the decision-maker do not reflect the underlying costs, that is the
"user pays" principle is not being applied. This tendency for competition to favour the high-cost product
seems to be a feature of card-based systems around the world and explains the increasing attention
given to the system by competition regulators.
Before I finish, I would like to reassure you that in some other parts of the retail payments system, the
normal laws of economics are leading to the normal results. The cheque provides the best illustration
of this. All over the world the cheque - universally acknowledged as a relatively high-cost means of
payment - is in decline, replaced by more efficient forms of electronic payment. The most important
reason for this is that banks at both ends of the payments chain are charging their customers for the
costs of writing and depositing cheques. So the "user pays" principle works well in this case, but of
course, there are no interchange fees.
At the Reserve Bank, we are in favour of a retail payments system that provides users with a wide
choice of options from a wide range of providers. Each payments method has its strengths and
weaknesses, and so users should be able to choose the most suitable payments method for each
particular type of transaction. In some cases the pricing of the transaction enables them to do so in a
manner which contributes to an efficient low-cost retail payments system, while in some other cases it
does not. The best way of improving efficiency is usually to increase competition rather than to
regulate, but I think I have shown that some parts of the retail payments system are constructed in
such a way that competition increases costs and reduces efficiency. In those areas, regulation is
required, and the Reserve Bank through the Payments System Board will continue with its task of
improving efficiency, competition and safety of the retail payments system.