The Corrosive Siege Over Signature-Card Interchange

10 Tipping Points for the Payments Industry Part 3 (Editor's Note: In its November-December 2006 issue, Digital Transactions magazine began a series of special analytical reports concerning the 10 most critical issues now confronting banks, processors, and merchants as they engage in handling electronic transactions. Written by noted researcher and analyst Steve Mott, the report saw its first two installments appear in the magazine, with the second running in the January issue. With this third installment, the series moves to Digital Transactions News, and will appear weekly here online and in the newsletter). The goose that has laid decades of golden eggs in credit card and signature-debit card interchange is getting long in the tooth. Usage has clearly matured, and most new demand is driven either by easy rewards for consumers who don't need to use signature-based cards or by easy credit for paycheck-to-paycheck households that increasingly use them to make ends meet. Make no mistake. Signature-card products have been wildly successful for the bank card industry, and have provided substantive value for users for decades. But maybe things have gone too far. This is a business so profitable?nearly $20 billion in 2005?that it can afford $35 billion to $40 billion a year in chargeoffs and do 6 billion direct mailings with a 0.3% response rate! Let's look at this largesse a bit more closely. If you divide the bank credit card industry revenue by an estimated 13.5 billion transactions, the average credit card transaction in the US winds up costing this society more than $8 each! About 80% of that comes from cardholders (in interest, fees, and penalty charges of various types), and the rest comes from merchants in terms of interchange. These costs for consumers, most of which are borne by households living paycheck-to-paycheck, shows credit card marketing has become a form of Russian roulette: How far can an issuer push financially challenged cardholders with punitive interest rates and fees before the bullet clicks into the chamber, and the user goes belly-up? With respect to merchants' costs, one recent study estimated that as much as 44% of that interchange revenue goes to support issuer rewards programs. But with more than 70% of credit card households having at least one rewards card, is there really any productive differentiation produced by that investment? Or have the bank card associations and their leading members just increased the costs of doing business for everyone? And what you'd normally expect to be the core costs that drive network-based pricing (interchange)?communications, processing flows, fraud, and risk management?all seem to be going down industrywide, thanks mainly to digital technology, while interchange just keeps going up! So today's merchants, billers, and corporates have great difficulty believing that current credit card usage, programs, and economics produce much in the way of incremental value for their business activities any more. This issue came to a head in 2003, with the Wal-Mart suit settlement. Since then, many of the largest national merchants have cut their own sweetheart interchange deals with the associations. But the vast majority of other bank card acceptors remain hopping mad. As a result, more than four dozen interchange lawsuits have been filed, which basically claim interchange rates keep rising purely because of market power. These suits generally seek some sweeping combination of rate relief, punitive rebates, and structural improvements in the rate-setting and negotiating process. Whatever the disposition of this immense legal challenge to interchange turns out to be, the effect on the payments industry is clearly corrosive. Merchant groups such as the Merchant Coalition and the Merchant Payment Roundtable have formed to explore new ways to transact electronically. Merchant relations are at an all-time low; processors and technology providers are feeling forced to take sides, while trying to support growth in new payments venues; and many smaller merchants (and financial institutions) are beginning to feel like they are being victimized in the process. Worse, mounting pressures on financially strapped consumers drowning themselves in too-easy-to-get credit have caught the eye of the new Congress. A host of both old and new inquiries are percolating?not least of which might be reconsideration of the restrictive changes on declaring bankruptcy passed in the last session of Congress. Even the Federal Reserve Board, long dormant on these issues, is finally waking up to all this friction. Prognosis: Ironically, the banking industry's own inability to calculate its costs and communicate its value propositions?justifying its pricing?seems bound to push the payments business to an unfortunate conclusion?including, perhaps, imposition of precipitous drops in rates. One solution: Push Visa and MasterCard to allow surcharges on expensive signature-card transactions in the U.S. (as they do in every other one of their five global regions). If merchants don't see the value or can't bear the costs of particular cards in particular markets, they can ask their customers to pay the freight; if the value is there, one or both of them should be willing to pay the costs. A wild card: MasterCard's new owners will undoubtedly push this new public company to settle early and often on these interchange lawsuits in order to get the negative overhang put to bed; why not opt for a constructive settlement and lead the industry to a more balanced and rational set of interchange rates that fit the specific market, product, and transactional cost circumstances?