Two Threats to Our Nation’s Economy
By Brian J. Donovan
October 20, 2009
The failure to regulate the U.S. credit card industry in a comprehensive manner and the lack of an adequately funded Natural Disaster Trust Fund are threats to our nation’s economy.
Issuing credit cards has become a highly concentrated industry. The top four card issuers, Citigroup, Bank of America, JP Morgan Chase, and Capital One, account for more than 70% of all credit cards in circulation.
Credit card networks have two distinct types of customers: credit cardholders and merchants. This type of business model is referred to as a two-sided network. On the one side, credit card networks collect annual fees, interest rates, and back-end or transaction fees from cardholders. On the other side, merchants must abide by onerous merchant restraints such as the no-surcharge rule, the no-discount rule, the honor-all-cards rule, and the no-differentiation rule. Merchant restraints are restraints on trade that distort competition among payment systems and encourage greater levels of credit card usage at higher prices. Since merchant restraints are restraints on trade lacking a pro-competitive justification, they should be banned as antitrust violations.
Credit card issuers receive 2.10% of every transaction from merchants in the form of an interchange fee. The interchange fee is set by the credit card processors: Visa, MasterCard, and American Express, which together control 93% of all card transactions in the U.S. Although Visa and MasterCard set the rates, it is their member banks, the issuers of the credit cards, that actually receive the interchange fees. Visa and MasterCard, along with the retailer’s bank, levy their own processing fees on top of the interchange fee, increasing the total fee to approximately three percent of every transaction. In 2008, credit card issuers extracted approximately $48 billion in solely interchange fees from merchants. This is twice the amount paid by consumers in credit card late fees. Interchange fees now comprise more than one-quarter of all credit card revenue and more than the total collected by banks in credit card late fees, over-the-limit fees, and ATM fees combined. These interchange fees, which amounted to $427 per household in 2008, are ultimately passed on in the form of higher prices to all consumers, whether the consumer uses a credit card or not. To induce consumers to use credit cards for more transactions, banks have created numerous rewards programs that give cardholders frequent flyer miles or other benefits every time they use their card. Rewards cards carry much higher fees than other cards, because these “rewards” are financed largely through the interchange fee paid by merchants. A low-income single-parent shopper paying with cash ends up subsidizing the free airline miles given to a high-income shopper using an American Express Delta Skymiles card. Credit card issuers make money on every credit card transaction, regardless of whether the consumer ultimately pays a finance charge. Just as with subprime mortgages, the current credit card business model creates a perverse incentive for credit card issuers to lend indiscriminately and ignore delinquencies.
According to a 2006 report by Chicago’s Diamond Management and Technology Consultants Inc.(“Diamond”), only 13% of interchange fees go to processing, which is allegedly the interchange fee’s original purpose, while the rest goes to paying for reward programs, and profits. According to Diamond, interchange costs are “paid for by merchants without directly benefiting them or their customer relationships. In fact, these rewards programs drive consumers to payment choices that are the most expensive for merchants.”
Many countries have brought antitrust suits against card issuers or otherwise used their regulatory authority to limit interchange fees. The list includes Australia, Brazil, Colombia, Germany, Honduras, Hungary, Israel, Mexico, New Zealand, Norway, Poland, Portugal, Romania, Singapore, South Africa, Spain, Sweden, Switzerland and the United Kingdom.
As interchange fee revenue has fallen in these countries, more credit cards, especially rewards cards, now carry annual fees. A significant benefit for credit card users in these countries is that interest rates have fallen, because banks are now using lower interest rates, rather than rewards, to compete for customers and drive transaction volume.
However, unlike other countries, the U.S. does not regulate interchange fees. While the Fed regulates the banks that issue credit cards, it doesn’t regulate the credit card industry or price competition in general. As Chairman Alan Greenspan wrote in a 2005 letter, “The Board’s regulatory authority does not currently encompass regulating the interchange fees established by payments networks.” The Department of Justice and the Federal Trade Commission, meanwhile, have given no indication that they plan to act. As a result, the average interchange fee in the U.S. is seven times the regulated interchange fee set by Visa and MasterCard in countries throughout the rest of the world.
Due to the fact the interchange fee is based on transaction volume, it creates an incentive for banks to issue as many cards as possible, regardless of the creditworthiness of the borrower. By creating a huge revenue stream unrelated to credit risk, interchange fees encourage credit card issuers to engage in reckless lending. Regulating interchange fees would not only protect small businesses. It would create a more efficient and competitive credit card market for consumers and eliminate a powerful incentive for banks to issue credit cards indiscriminately and to ignore delinquencies.
The problem is further compounded by securitization, in which banks package and sell credit card debt to investors (just as they’ve done with mortgages). The banks continue to make money on interchange fees, while the investors assume all the risk of cardholders defaulting.
The manner in which our nation attempts fund the recovery of areas devastated by natural disasters is even more disconcerting than its failure to comprehensively regulate the credit card industry. For example, New Orleans will lose approximately $1 billion in allocated GO Zone bond financing at the end of this year. The Gulf Opportunity Act of 2005 gave Louisiana the authority to issue approximately $7.9 billion in tax-exempt private activity bonds (“GO Zone Bonds”) that could be used for acquisition, construction, reconstruction, and renovation of nonresidential real property, qualified residential rental projects, and public utility property in 31 parishes across southern Louisiana. The State Bond Commission set aside approximately $1.3 billion for projects in New Orleans. Although $497 million has been earmarked to developers who hope to complete financing of their projects in the near future, only $55.6 million of GO Zone bonds has been issued for projects in New Orleans. Unfortunately, while GO Zone bonds would be attractive to investors during a healthy economy, tight credit markets and difficulty finding investors willing to buy the GO Zone bonds have made it virtually impossible for developers to use the bonds.
Non-refundable tax credits are a viable financing incentive if potential investors have taxable income. Bonds are a viable tool if banks are ready and willing to lend. Unfortunately, our current economy lacks both a sufficient number of investors with taxable income and banks ready and willing to lend.
Congress has found that our nation needs transformational energy-related technologies to overcome the threats posed by climate change and energy security, arising from its reliance on traditional uses of fossil fuels and the dominant use of oil in transportation. Likewise, Congress should find our nation needs a transformational business model to overcome the threats to our economy posed by our failure to: (a) regulate the U.S. credit card industry in a comprehensive manner; and (b) establish an adequately funded Natural Disaster Trust Fund.
It is time to disrupt the status quo. The following article argues that legislation to reduce the interchange fee from the current 2.10% to 0.6% in the U.S. will provide adequate funding for the establishment of a Natural Disaster Trust Fund. In 2008, such legislation would have saved merchants (and thus consumers) $34.3 billion in interchange fees.