Academic journal article Chicago Fed Letter

Payments Pricing: Who Bears the Cost?-A Conference Summary

Academic journal article Chicago Fed Letter

Payments Pricing: Who Bears the Cost?-A Conference Summary

Article excerpt

As consumers and merchants increasingly adopt electronic payments, the pricing of these services has generated substantial scrutiny by public authorities around the world. To discuss these developments and related issues, the Federal Reserve Bank of Chicago hosted its ninth annual Payments Conference on May 14-15, 2009.

For some time now, merchants have spoken out about their inability to influence their customers' payment choice or to pass along the costs of payment instruments such as credit cards to their customers. The card networks, such as Visa and MasterCard, have received the brunt of the pricing criticism across the globe as public authorities seek to restructure paymentcosts . Yet, the networks argue that the fees they charge reflect the market value of their products. Consumer advocates often claim that consumers are unaware of the impact of their payment decisions and that some consumers end up subsidizing the payment choices of others. Adding to the mix, many nonbank payment providers are bringing innovative payment products to the market to satisfy changing consumer and merchant preferences and needs.

In an efficient market, prices and benefits are aligned in a way that provides all participants with proper incentives to maximize social welfare.1 If the costs and benefits of the payments system are not aligned in such a way, will regulation be required to bring the system into the proper balance? Or will the market resolve the problem through innovation? In this Chicago Fed Letter, we summarize this year's Payments Conference, where the participants discussed these and related issues.

The current environment

In his keynote address, David Stewart, of McKinsey and Company, described how the weakened U.S. economy and growing regulatory pressures are influencing the payments landscape. Payments revenues saw a 5.9% compounded annual growth rate over the period 2002-07, according to Stewart, but in the next five years, this growth may slow to 1.3%. Such a decline might be expected in a sizeable downturn, but there are particular factors in play this time that suggest the impact might be felt differently by different players. Deposit balances were the highest ever in 2008, Stewart said, as people cut back on consumption; and the supply of credit also diminished greatly, since risk aversion increased throughout the market. Debit card usage was growing much more rapidly than credit card usage before the downturn, and current conditions may bolster this trend. Furthermore, with consumer spending weakening, merchants may attempt to reduce costs by steering consumers toward payment types with lower merchant fees.

In addition to such pressures, pricing practices for payment products are becoming increasingly scrutinized by public authorities globally. Financial institutions are now struggling to find pricing models that replace their reliance on traditional sources of revenue, such as interchange fees2 from merchants and penalty fees from some consumers, including over- draft fees3 and finance charges on credit cards. Penalties currently make up a large portion of the consumer revenue stream from payment products as a re- sult of competitive developments in the payments space. Forty years ago, when checks were the primary noncash pay- ment instrument, consumers paid for them, explained Richard Oliver, Federal Reserve Bank of Atlanta. This model gave way to differential pricing based on minimum balances, which rewarded consumers who kept more money in their accounts. Once that model became ubiquitous, financial institutions introduced today's indirect pricing model, which removed upfront fees (e.g., free checking and no annual fees on credit cards), to retain customers, according to Oliver. But this model is difficult to sustain, since it effectively shields many consumers from the consequences of their payment choices while adversely affecting others.

The debate over pricing issues

The two-sided4 nature of payment products makes it difficult to determine whether the costs of such products are being properly distributed to promote social welfare. …

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