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The Interchange Cross-Subsidy: False Analogies

posted by Adam Levitin

Zywicki's interchange paper repeats a claim made by other opponents of interchange regulation that cross-subsidies, even regressive ones, exist throughout the economy, so there's no reason to get worked up over the interchange cross-subsidy imposed by credit card network rules. 

Zywicki provides several examples of cross-subsidies in the consumer economy:  Starbucks charges the same price regardless of whether a consumer takes sugar and cream, so those who take their coffee black subsidize the sugar and cream of the others.  Supermarkets offer free parking, so the walkers subsidize the drivers. 

Zywicki's examples, however, are false analogies to the credit card interchange cross-subsidy from users of low cost payment methods (cash, debit, nonrewards credit) to users of high cost payment methods (rewards credit).  The Starbucks' cross-subsidy is Starbucks' business decision.   The free parking cross-subsidy is the grocery store's business decision.  But the interchange cross-subsidy is not the merchant's business decision.  It is the card network's business decision.  Card networks force merchants to impose a cross-subsidy.  It's an affront to the nose-picking rule of commerce:  you can pick your friends, you can pick your prices, but you can't pick your friends' prices....

With this in mind, it's worth examining another cross-subsidy caused by interchange.  Interchange fees are paid from acquirers to issuers.  The fees are the same for all banks.  Therefore, the safer banks are subsidizing the riskier banks in a card network.  But there's a catch.  The safer bigger banks often get rebates from the card network in addition to interchange fees. 

Two interesting points about this.  First, it shows that the card networks won't tolerate cross-subsidies for themselves. Second, it casts some doubt on the efficiency rationale for interchange fees--that one-size-fits-all fees are sensible as a way to avoid the transaction costs of individually negotiating every issuer-acquirer contract.  Truth is that 20 or so banks make up 95% of the credit card market.  The transaction costs for these banks to negotiate with each other is fairly low.  This points to the question of whether small banks should be in the card business at all.  Cards are very much an economy of scale business; smaller issuers tend to see cards as loyalty devices, not profit centers.  Would a 20-bank card market be a more efficient arrangement than the current networks with thousands of institutions? I'm not sure, but I think the efficiency of the interchange system is far from proven.


I thought that there were many acquirer banks, including many small banks. The economies of scale are with the issuer banks, which are very few. I always thought that is why the acquirer banks get screwed by interchange, to the benefit of the issuers.

The acquirer market is not as concentrated as the issuer market. By my quick calculations from Nilson data (I'm looking at 2008 numbers, but the 2009 are likely substantially similar), it seems that the top 20 acquirers have around 75% of the total credit and debit (signature and PIN) market.

The acquirers don't exactly get screwed with interchange--most of them just pass it through to merchants by charging a spread over interchange (or over interchange plus network fees).

Let me correct myself--my 2008 numbers don't seem to be correct; I probably had a slip-up on the calculator when running the numbers. This Fed study puts 2006 acquirer concentration much higher: top 10 acquirers having 88% of MC/V volume.


The acquirers, admittedly, make some money. (They would have to, if there are any acquirers who aren't issuers.) But that's a vacuous statement. Anybody who transacts with a monopolist is better off than if they didn't. That doesn't mean that the acquirer (or the merchant or consumers to whom part of the monopoly price is passed on) doesn't get screwed.

Thanks for the enlightenment on acquirer concentration. It is worse than I thought.

Grocery stores do not have the option not to provide parking. Nearly every municipal code in the U.S. requires businesses like grocery stores to provide parking. See, e.g. http://www.uctc.net/papers/351.pdf

The card issuer is a business just like a retailer, a card company may decide to offer a 0% apr for 15 months with no rewards, and a student card with 2-3% cash back for students who are often low income. What the card issuer decides to do is a business decision, if the credit card companies gave most of their money to low income charities , this would not be issue, but its a question of personal moral and business decisions rather than a signal of a problem.

Tj maxx's fraud and negligence was born by the credit card companies, similarly stores and merchants who are decent in preventing fraud and taking additional steps may subsidize those who don't, adam is also wrong on the cost argument.

A big business who has to deal with employee theft and armed security guards, may find it worthwhile to pay 2% interchange fees, although he/she via special interest legislation would rather pay less or be given the opportunity to pay less and get away with via bait and switch tactics.
Checks are not accepted by certain business due to fraud and the merchant knows they not the card companies will be on the hook.

Nonrewards credit and other payment methods are not necessarily "cheaper" to every merchant, similarly durbin's interchange would result in smaller companies getting bigger rates via credit union then big banks.

I've explained interchange fees don't necessarily result in a regressive consumer method it can be progressive.

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