Payment networks are the backbone of any well-functioning financial market. Specifically, retail payment networks allow buyers of products and services to transfer monetary value to sellers. Increasingly, these monetary transfers are initiated with payment cards. Payment cards are generally characterized as a two-sided market. Rochet and Tirole (2006) define a two-sided market when the price structure, or the share that each type of end user pays the platform, affects the total volume of transactions. The key aspect of these markets is the presence of indirect network externalities and how fee structures are able to internalize these externalities. Often platforms subsidize the participation of one type of end user by extracting surplus from another type of end user to internalize this externality.
Payment card networks are composed of consumers (one type of end user), their financial institutions (issuers), merchants (the other type of end user), their financial institutions (acquirers), and a network operator or platform. A consumer makes a purchase from a merchant. Generally, the merchant charges the same price regardless of the type of payment instrument used to make the purchase. Consumers often pay annual membership fees to their financial institutions for credit cards and may pay service charges for a bundle of services associated with transactions accounts, including debit card services. Merchants pay fees known as merchant discounts. Acquirers pay interchange fees to issuers.
The level of interchange fees continues to receive attention around the world by public authorities. A small but controversial section of the Dodd-Frank Wall Street Reform and Consumer Protection Act passed by the U.S. Congress and signed into law by the president in 2010 gives the Federal Reserve the authority to regulate U.S. debit card interchange fees to promote a more efficient retail payment system. The Reserve Bank of Australia regulated interchange fees in 2002 after concluding that consumers did not face the correct incentives to use the most efficient payment instrument. The European Commission in 2007 ruled that Mastercard’s interchange fees violated the EU’s antitrust laws. Additionally, the European General Court judgment of May 2012 confirmed the commission’s finding in its MasterCard Decision of December 2007. Alternatively, the reduction in interchange fees may also occur without regulatory intervention, as occurred in the United States when card networks convinced large department stores and grocery stores to accept payment cards by reducing interchange fees, which resulted in lower merchant fees.
The economic theory regarding interchange fees predicts that by lowering the optimal interchange fees, some merchants not currently accepting card payments may start to accept them. However, lowering interchange fees would increase cardholder fees, and some of them may abandon their payment cards or use them less frequently. However, changes in external factors such as greater awareness of the benefits of payment cards or reductions in processing and credit intermediation costs may result in greater adoption and use by consumers even when consumer fees increase resulting from interchange fees being lowered by the card network or by government mandate.
Using a unique Spanish proprietary bank-level data set, we study the impact of interchange fee reductions from 1997 to 2007 on merchant acceptance, consumer adoption, payment card transaction volumes, and issuer and acquirer revenues. Our main results are as follows. First, we find strong evidence suggesting that merchant acceptance has increased because of a reduction in interchange fees. Second, consumer adoption of debit cards did not significantly decrease over the period because of lower interchange fees, as would be predicted by theoretical models absent changes in external factors. Credit card adoption increased dramatically during the period of interchange fee reductions, suggesting the value proposition for those consumers previously not having credit cards improved despite higher fees. Third, most important, reductions in interchange fees resulted in a dramatic increase in payment card transactions during this period. Fourth, bank payment revenues from debit and credit card services increased as a result of lower interchange fees. Our results for bank revenues suggest that the increase in the number of transactions appears to offset the decrease in the per transaction bank revenue.
Our paper is organized in the following way. In the next section, we survey the main theoretical and empirical studies on interchange fees. Section III analyzes the industry and the data. We discuss our empirical strategy in section IV. In section V, we present our results. We offer some concluding remarks in section VI.