Yet More Financial Innovation

Andrew Martin has an article in The New York Times on the dynamics of the debit card industry. I don’t have any expert knowledge to add, but here’s the summary: Visa has been increasing its market share by increasing the prices it charges to merchants; it takes those higher transaction fees and passes some of them on to banks that issue Visa debit cards, giving them an incentive to promote Visa debit cards over other forms of debit cards. Not only that, there are different fees on debit cards depending on whether you use them like a credit card (signing for them) or like an ATM card (entering a PIN). Signing costs the merchant more, so the banks and Visa give you incentives to sign instead of using a PIN. The end result is higher costs for merchants, who pass them on to you.

Ordinarily this should create the opportunity for a new entrant (say, NewCard) to offer lower fees. But there are three problems that I can see. First, individual customers would have no incentive to use NewCard rather than Visa, since any savings get distributed across all customers of a given merchant (through lower prices). Second, there are massive technological and marketing barriers to entry. Third, even if merchants and customers want NewCard, the banks–the distributors of debit cards–don’t.

Tell me again, how does this benefit society? Theoretically having a couple of big transaction processing networks could lower costs relative to having a lot of smaller networks because of economies of scale. But we’re probably talking a couple of pennies per transaction there, while the fees that Visa charges are an order of magnitude bigger.

Update: It struck me that I have in the past cited the debit card as an example of a beneficial financial innovation. I may have to rethink that. Sure it provides benefits, like not having to carry around lots of cash. But I’m not sure those benefits are worth the amount that the networks and the banks are sucking out of the system (resulting in higher prices for everyone).

By James Kwak

45 thoughts on “Yet More Financial Innovation

  1. Terrific post. I have read that one of the ways banks are planning to increase profits, especially with people more wary/cautious about using credit cards with the economic crisis, is through increased and new creative fees on debit cards. I think this will come to fruition (if it hasn’t already) and it behooves people to keep an eye on it on their monthly statements and news on debit cards.

    There was a guy on NPR’s “Fresh Air” today (January 4), I think his name was Bill Sullivan and he had many useful things to say that people should know about the way banks “nickel and dime” you to death with cards, loans, and hidden fees. Even for those who think they are well informed should take a listen to that show. January 4th “Fresh Air” from NPR.

  2. James,

    Society is not benefited by this kind of rent-seeking. Unfortunately, our politicians do not understand what rent-seeking is. As a result, they confuse false GDP created by rent-seeking for real GDP and choose to look the other way as the rentier class imposes private taxation-without-representation on society. Very sad.

    Something will break soon, and this practice will come to an end, at least temporarily. The only question is what else will be destroyed in the process.

    In the meantime, EVERYONE should move away from debit cards and insist that their banks re-issue plain old ATM cards. I did this recently, and I am very glad I did (even thought they lied and said that I could not buy groceries at Safeway using my ATM card, when I can). Better yet, use cash to make purchases, if you have it.

  3. Many observers will label you a dinosaur for saying use cash, but I agree with you TOTALLY. Of course not large amounts and not when you’re traveling, but generally cash is still a good way. If you’re not getting ATM fees (or getting them refunded by your base bank, like Kwak is) just use that ATM card and cash. Then you KNOW you’re not getting some bullshit fee. Those card fees, ATM and debit card fees, are like AN INTEREST RATE YOU GET CHARGED FOR USING YOUR OWN MONEY. And if people stopped to figure out what that fee equates to as an interest rate, they would know it’s a modern form of usury by the banks.

  4. First, banks increase their market share by passing some of the fees off to customers (cash-back). And one would presume, if the banking market is competitive, by offering better services for their accounts (higher rates, lower other fees etc), than they otherwise would.

    Second, NewCard is arriving. By paying via phone bills, mobiles, PayPal, direct transfers etc. So VISA is not only competing against AmEx/MC etc, but against all those other types of payment. If they get too greedy, they will soon be out of business.

  5. This wouldn’t be a problem if retailer were allowed to pass the fee along to customers who use the cards.

    When I owned a coffee shop, the transaction fee ate profits and we limited the amount that could be charged in response.

    Do you know if transaction fees are charged with a debit card?

  6. Cash-back, points, miles and other customer “loyalty” programs do exactly the same thing and have been around forever.

  7. Beware, when the big banks reissue cards (they do this periodically to update info like network provider logos), they often issue them as debit cards without a PIN – to maintain a debit card with a PIN it is necessary to call and specifically request it in an assertive manner. The debit cards with PINs are much more secure, not only because of the PIN but also because scams are much easier to run on cards without PINS.

  8. The only problem with using cash instead of a credit card is that you get hit with the higher prices merchants charge to make up for the interchange fees they are forced to pay by the card issuers. In exchange for the higher prices you get certain “rewards,” for using your credit card. When it comes to debit cards though you still have to pay the higher price merchants pass on to you, but you don’t get anything except the convenience of not having to carry around cash. Unless you really can’t manage to pay off your balance at the end of the month there really isn’t any good reason why you should be using a debit card over a credit card. Although, before the financial crisis hit there was a proliferation of “rewards checking accounts,” that were offering unusually high interest rates on your deposits if you used your debit card a certain number of times per month (usually ten). Those kinds of accounts are now all but gone. Mike Konczal over at rortybomb had two very goods posts a while back about the dilemma consumers face over interchange fees:

  9. So, exactly how much cheaper would products be if this visa tax did not exist?

    If you had a hard figure to show maybe this would shock costumers into some kind of action.

  10. As a completely off topic post, could Mr. Kwak or Johnson share some thoughts on the situation developing in Iceland?

  11. James —

    It was an interesting article. I kept waiting for the reporter to discuss the issue of fraud. He notes that using the pin/debit vs the signature/debit makes the card less subject to fraud. But of course customers don’t care whether the card is used fraudulently: they are fully covered with zero liability for cards that I know of. It is the bank that pays. And so you have to assume the bank factors that into their model: loss due to fraud, made easier by their own desire that customers use signature over pin. Pretty sick, no?

    I wonder if one could quantify how much of these transaction fees are going to cover fraud made easier by the banks’ policies?

  12. what about elasticities and incidence; also citing the NRF for costs is somewhat misleading. while the payment processors may have engaged in anticompetitive behavior, the writing on the subject seems to be a knee-jerk anti-financial services analysis which (for the nyt at least) is a pretty good story to write at this time.

  13. Merchant rates have been on the order of 2% but may be approaching 3%. This rate is small enough that consumers tend to ignore it in return for the convenience and perceived safety of not carrying cash. For the merchant the increased overhead is offset by consumers’ tendency to buy substantially more stuff when they use a credit or debit card.
    A decade ago, grocers, an extremely low profit margin operation, would never accept anything but cash or check. Now they readily accept debit and credit cards; their sales increase 10-20% when customers use those forms of payment.

  14. “The fees are “not a cost-based calculation, but a value-based calculation,” said Elizabeth Buse, Visa’s global head of product.”

    Can someone translate this from MBA weasel language?

  15. “Tell me again, how does this benefit society? Theoretically having a couple of big transaction processing networks could lower costs relative to having a lot of smaller networks because of economies of scale. But we’re probably talking a couple of pennies per transaction there, while the fees that Visa charges are an order of magnitude bigger.”

    The mindset of financial types is rent-seeking. I have actually heard discussions of other ways to to pull a fraction of a cent out of billions of transactions. This is how they think, and what they do. Of course, it is not productive. This is about capturing a disproportionate share of the nation’s wealth, not by adding value but because they can extract rent “under the table.”

  16. Nothing is certain at this point, however, my question is whether this is a special case or a precedent?

  17. There is really only one way to compete in this market locally. That happens when large enough group of merchants issue their own credit or savings accounts.

  18. “Tell me again, how does this benefit society?”
    The bank interest groups say that it is replacing checks and cash and all that ‘hassle’ they had to deal with. “We charge for value”, they also say. “People need to keep in mind what it used to be like and how their business model has changed”.

    How any of this passes for an argument is beyond me.

    They are stealing from and taking advantage of the people who can afford it least. My little brother walked out of the bank with $75 in his account. He walked in with a $350 check – it’s just heartbreaking when you see the consequences.

  19. Translation: “We charge more than it costs, because we can. (And our competitors do, too. :))”

  20. This is what I thought too. It’s Office Space, only backwards, which somehow makes it legal.

  21. Over this past holiday I used my Macy’s charge card for the first time in maybe two years. They had to “reactivate” the card. A week or so later I received in the mail a notice that Macy’s had opened a Visa card for me — separate from my Macy’s card — a stand alone Visa card. They’d made NO request for my permission to take this action, or even mentioned that they were taking this action. Out of control.

  22. I do not understand the difference you are drawing between a debit card and an ATM card, and I would lay money that the merchant is getting charged the same interchange fee for both (if there is a difference).

    There is a collective action problem at work here. Everyone other than the banks would perhaps be better off by not using cards that carry interchange fees. The card offer a convenience, and once some people decide its worth the cost, we all end up paying for a small part of it, and pay more if we opt out of the “rewards,” so everyone uses them.

  23. Except that fraud rate in the U.S. are already very, very low, which is why you haven’t seen much adoption of smart cards.

    Also as most banks (even the big ones!) will refund dispute debit charges these days, it generally isn’t that big of a deal. At BoA, I once had a few mysterious charges as a debit card. Fifteen minutes on the phone (although I did have to start over with three different people) ended up with the bank service person argeeing that it looked like fraud and sending out the (surprisingly simple) paperwork along with a fedexed replacement card.

  24. The hysteria on this issue is kind of amazing. Visa is a network. Different lenders offer payment cards that work on that network. Macy’s (or more likely, whichever financial institution they have outsourced credit to) is still the lender on your card. It just now also carriers a Visa label (and likely can be used far more widely than in the past and likely comes with a Macy’s loyalty rewards program).

  25. If you feel comfortable entering both your PIN and ATM card number in hundreds of merchant computer systems, leaving your bank account vulnerable to theft, be my guest. Until that issue is resolved, I will continue to sign my debit card transactions.

  26. No surprise at all. When a business thinks it has achieved the toll bridge status, it will begin to do this sort of things. History has repeated itself many times. They have figured out there is no way the consumers can get around. Warren Buffett has long figured this out — If there are two newspapers in town, the consumers will benefit but both newspapers won’t make much money. If one defeats the other, it becomes a cash cow. It can raise ad price and people will have to comply.

  27. Our locally owned auto repair shop has a small sign on the counter that says: “1% discount for payment by check”. Not much money if you are just getting an oil change – but move on up to brakes, shocks and a few more items and you’ve got the price of lunch. Yes, owner did it because of fees charged by credit card companies.

  28. This is why I think that with each new financial innovation there are a 1000 suicides caused (karma), and for each additional dollar of profit gained by such innovation, a bucket of tears is shed. Time to take this country back from Wall Street, and establish greed as a crime, not just a sin.

  29. I read that last night and decided I was going back to paper checks and cash as much as possible. And the checks will cost them more to process – added bonus.

    After reading “Bye, Bye, BOA”, I have really become determined to find another bank. The whole Wachovia debacle left me in the clutches of Wells Fargo, and the only reason I haven’t bailed before now is that I really love the gals at my local branch – they have been super, no matter what name was on the door – from First Union to Wachovia and now WF. Still, there’s a BB&T right across the street, and I can always switch to my credit union………

  30. How about permitting merchants to charge extra for non-cash transactions? Online retailers charge more for credit than debit cards and Ryanair is a particular villain in abusing this “right”.

    I’m ignorant of US law, but I understand that High Street (UK for “Main Street”) retailers aren’t permitted to charge extra for cards – hence spreading costs in ticket prices.

  31. Carrying cash or writing checks may not be the answer if the merchants accepting debit or ATM cards raise their prices to compensate, since all customers pay these higher prices anyway, even for cash transactions.

  32. Logistically speaking,each credit card transaction costs the same.So why are the card companies/banks charge commission fees ad valorem to merchants,thus inflating prices to consumers?

  33. Great post revealing what card issuers want hidden. But why use a debit card in the first place? I use a single credit card, pay a small annual fee (which I coul avoid by changing to a card that didn’t pay miles), collect a lot of miles and pay it off in full every month. Is the retailer getting charged a fee that is reflected in the cost of goods? Sure he is. But I wouldn’t get a lower price if I paid cash or used a debit card. The card gives me flexibility with my bank balace throughout the month, all the buying power I need, and only requires a little discipline to use properly. Besides, it drives the card issuer nuts because it never gets to charge me interest. The annual fee is a pain, but I figure I pay that to get miles (and believe me, I get thousands and thousands of miles all the time) and the benefit of the float during the month. I only withdraw cash using a virtually universally recognized bank card, although I pay a small fee when using a noon-member bank, which is seldom necessary. Am I missing something here?

  34. I seem to recall (sorry I don’t have time to search right now) that merchant databases were hacked into. And it was the debit transactions with pin numbers that were compromised, while the credit transactions had no problem. This is the reason I have tended to favor using a card as a credit card rather than as a debit.

    Does anybody remember/know anything more about this?

  35. Why not legislate that the excess cost of the credit card fee be added to the bill? As a simple example, if the typical cost for a merchant to handle cash is one percent, then a card that levies a two percent charge would lead the bill to the customer to be one percent above that of a cash customer. A customer who instead offers a card carrying a three percent fee would have a bill higher by two percent and so on. As it is, cards that charge higher fees can afford better “rewards” to customers. This change would give customers the incentive to use the low fee card instead.

  36. There could have been a debit competitor but the Justice Dept made sure there wasn’t. Several years ago when First Data bought Concord EFS, one of the assets it acquired was the STAR debit network. FDC already owned the NYCE debit network. FDC fought hard to convince Justice that this was a chance to bring some competition to VISA/MC but Justice, as always, knew better. FDC was forced to sell off NYCE and now the stand-alone debit networks are all pretty much powerless. VISA has always operated to benefit a few large issuing banks to the detriment of both merchants and small banks. The Justice Dept saw to it that VISA would not be challenged. “Justice Dept” is a total oxymoron.

  37. Thought I’d share my recent story at a local bank (as I’m looking to potentially move my mortgage to a local bank that would service the loan (vs selling it).

    They have a 4% interest checking account whose twist includes 15 debit transactions a month. I told the rep that I wasn’t a big fan of debit cards as they have significant charges to the merchant… He interupted my comment as I was finishing to tell me ‘but you don’t get charged!’, at which point I proceed to let him know I thought that by charging the merchant, I will eventually pay by higher prices (or already am). He looked at me like I had two heads.

    What I think is impressive that the funds in play make it worthwhile for Visa, the bank’s cut, and the checking account owner (at 4% interest). The merchant has to be losing their shirt! It was a bit depressing to know that there is that much fat in the system today.

    I think I’m going to bust out my checkbook like the good old days. I haven’t seen people pay with a checkbook at the grocery store in forever. I’ll try to start the comeback fad here. I know the argument that I’m paying the inflated prices already, but I would love to see cash discounts come around like at some gas stations, maybe hopefully in grocery stores soon?

    I’ll also complain to the bank about their 4% account and see if that goes anywhere.

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