Linkages Between Consumer Payments and Credit

Payors, those that make payments, and payees, those that receive payments, choose among various payment instruments based on their preferences toward convenience, risk, and cost. According to a recent U.S. survey, the usage of payment cards is increasing as a proportion of in-store sales while check usage continues to decrease (American Bankers Association and Dove Consulting 2005). Recently, a café in Washington, D.C. stopped accepting cash for purchases primarily because of the cost of safekeeping (National Public Radio 2006). This shift toward electronic payments is occurring because they offer greater benefits to a growing set of consumers and merchants.

There are two forms of credit associated with payments—payment credit and consumption credit. Payment credit is the credit that is extended by the receiver of payment or a third-party until the payment instrument is converted into good funds. For example, payment credit is granted by the recipient of funds when she accepts a check in exchange for goods and services. Today, greater use of real-time authorization systems along with faster clearing of payment instruments has significantly reduced payment credit risk. Consumption credit is extended by the payee or a third-party, which is separate from payment credit. For example, credit card issuers extend credit to their cardholders, which can be paid at the end of the billing cycle or over a longer time period. Cardholders choose when to pay back these loans subject to minimum payment requirements. Financial institutions also offer overdraft facilities to reduce payment defaults on checks due to non-sufficient funds and fees associated with bounced checks. While consumers bear the cost of overdraft facilities, merchants benefit from potentially fewer bounced checks. Similarly, payees can contract with third parties to reduce this risk as well.

A key issue that has received attention globally is the pricing of payment and consumption credit to consumers and merchants especially for payment cards. In the case of credit and debit cards, merchants pay a fee to their financial institutions, called acquirers, for each payment transaction. Acquirers pay interchange fees to issuers, those that issue payment cards, for each transaction. In the case of credit cards, some have argued that issuers use their revenue from interchange fees to encourage consumers to make more purchases with their credit cards instead of less costly payment instruments such as PIN-based debit cards. Defenders of the current interchange fee pricing structure argue that the fee is necessary to balance the demands of consumers and merchants. In other words, both consumers and merchants benefit from the extensions of credit.

After discussing the costs and benefits of major retail payment instruments, Chakravorti reviews a number of regulatory and legal challenges to the payment card industry. Most of these challenges question the degree of competition and its impact on consumer and merchant welfare. Following this discussion, he reviews two academic models that focus on the benefits of consumption credit to consumers and merchants along with how that credit is priced.