James J. McAndrews

English

Research Papers in Economics

NOVEMEEE/DECEMSER t 995
James J. McAndrews is a senior economist and research advisor at the Federal Reserve Bank of Philadelphia.
--V Commentury
James J. McAndrews
‘m honored to speak before such a well-
informed audience and after such
I thoughtful and intelligent speakers,
and I wish to thank the Federal Reserve
Bank of St. Louis for sponsoring, and
especially R. Alton Gilbert for organizing,
this symposium. My comments today do
not necessarily represent the views of the
Federal Reserve Bank of Philadelphia or
the Federal Reserve System.
The paper by Carlton and Frankel
(1995) is excellent. It focuses on two
issues of concern in credit card joint ven-
tures: the collective setting of interchange
fees and exclusionary restrictions on
membership in the system. I agree with
their conclusion that collective exclusion
of competitors can harm consumers and
with their estimates of the relatively
weak importance of systems competition
in the credit card marketplace. The evi-
dence that Carlton and Frankel produce
concerning credit card pricing in the
wake of the AT&T and GM market entries
is compelling.
I’ll speak on threeissues raised by the
paper: collective setting of interchange
fees, the possible benefits of duality agree-
ments when systems competition (called
end-to-end competition by Professor
Economides) is imperfect and finally the
anticompetitive effects of collective
restraints in associated product markets.
All of these issues have a common
aspect—namely imperfections in competi-
tion between payment systems.
1131355:1553
Carlton and Frankel explain how col-
lectively set interchange fees can be used
to generate more revenue for members of
credit card systems at the expense of mer-
chants when there are imperfections in the
payment systems market. They remain
“unconvinced ... whether interchange fees
are, on net, a procompetitive or anticom-
petitive practice.” It is illustrative tocom-
pare these interchange fees with those
used in the purely private-sector checking
system in the National Bank period of
1863—1914, The history of the National
Bank system does not offer much support
to the view that collectively set inter-
change fees were used in an anticompeti-
tive way
During that period, as recounted by
Cannon (1908) and Spahr (1926), banks
did impose interchange fees for the collec-
tion of checks. They called the fees, sim-
ply exchange fees. The clearinghouses
created in that era were organized primari-
ly to exchange local checks and toestab-
lish a uniform set of interchange fees and
collection times. The collection of out-of-
town checks, known as foreign checks,
was a complicated business. Because of
the ad hoc nature of the many bilateral
interchange fee agreements, checks would
sometimes travel thousands of miles before
being presented to a bank only dozens of
miles from the hank of first deposit, all to
avoid an interchange fee of one to one and
a half percent.
Part of the Fed’s mandate was to estab-
lish a national system of payment, and it
succeeded, by and large, in establishing
par exchange for checks quite early in its
history Par exchangeability is the same as
zero interchange fees and is, of course, the
desired goal of Salop (1990), which
Carlton and Frankel mention. But par
exchangeability came about nationally
only after the establishment of the Federal
Reserve System. Even local clearinghous-
es, according to Cannon (1908), charged
positive (but uniform) interchange fees,
often as little as 15 basis points, which is
less than if they had been set unilaterally
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Outside the local clearinghouses, the
evidence is consistent with Baxter (1983),
Kauper (1988), and Gilbert (1991), who
conclude that unilateral decisions on
interchange fees can result in an ineffi-
cient set of fees and can lead to costly and
complicated countermeasures to avoid
transactions with particular members of
the network. The authors attribute these
inefficiencies to network economies of
check clearing. The Fed, as the check
network operator, was able to enforce a
particular uniform fee of zero. In choos-
ing a uniform interchange fee, the Fed
was constrained by the common law
history of par exchange under direct pre-
sentment. Par exchange, as mentioned
previously is the exchange of checks at
par value, with no interchange fee. Based
on this history the Fed chose an inter-
change fee of zero. Absent that common
law constraint, the Fed may have chosen a
positive interchange fee. As I mentioned,
the local clearinghouses set positive inter-
change fees.
I therefore believe that we would not
see zero interchange fees in checking
today had the Fed not been created. The
level of fees chosen collectively by the
private clearinghouses, however, was sub-
stantially below’ the level chosen unilater-
ally bybanks. I believe it is unlikely that
they were used anticompetitively In any
case, the arbitration by Kauper in the Fir-st
Texas Savings Association case suggests
that interchange fees that are carefully
matched to cost can he upheld as legal,
and I think that this decision will stand
further challenges.
DUALITY IN THE CREDIT
CARD SYSTEM
Carlton and Frankel argue that duality
in credit card systems may contribute
to a more competitive credit card market.
They cite the apparently procomnpetitive
merger of two regionalATM networks—Cash
Station and Money Network. I wish to
further support this thesis by reviewing
evidence of greater competition within
the two national ATM networks, Cirrus
and Plus, following their duality agree-
ment. In addition, I’ll take a closer look at
imperfections in systetus competition that
suggest that duality or cobranding may
provide a remedy for two imperfections in
ATM systems competition.
The two leading national ATM net-
works agreed to a limited form of duality
in 1990. It was a more limited form of
duality than that seen in credit card net-
works. For a low fee, the agreement
allowed a single bank to put eithernet-
work’s logo on its machines, hut not its
cards. The growth ofATM locations affili-
ated with Plus or Cirrus before and after
duality suggests that the arrangement was
welfare enhancing. Using data supplied by
Plus and Cirrus, Kauffman and Wang
(1992) have fitted growth curves to the
data on Plus and Cirrus ATMs from the
inception of the systems in 1984 through
1992. The actual growth of ATM locations
affiliated with each network exceeds the
amount of growth that would have been
predicted based on the preduality experi-
ence. There was no similar boost in the
total number ofATMs nationally
Furthermore, transaction volume doubled
for Cirrus and Plus between 1990 and
1992, whereas for regional shared net-
works as a whole, transaction volume
mci-eased by only 30 percent. As in credit
cards, these developtnents can reflect either
a procompetitive response of the systems
under duality (and there is excellent anec-
dotal evidence that Cirrus in particular
took advantage of duality to compete more
vigorously) or an increased value of mem-
bership in each of the systems because of
network externalities, or economies of
ubiquity in demand. Either interpretation
is consistent with a view that duality can
enhance efficiency Given this evidence of
increased output under duality showing
that duality is, on net, harmful, will require
more significant evidence of harm than has
been found or suggested so far.
Indeed, determining whether exclu-
sionary rules enhance efficiency requires a
careful consideration of the nature of the
competition under the exclusionary rules
and consideration of how’ this competition
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56II [Yl[~
NOVEMEEE/DECEMSER ‘995
would be affected by something similar
to cobranding or duality or by a merger
of systems.
It is often the case that the systems
competition we observe in payment sys-
temsunder exclusionary rules is imperfect.
In ATM networks, as in the early credit
card merchant processing business, there
are high costs to consumers when chang-
ing networks (because of their need to
switch banks to gain access at a different
network) and to banks of location-based
product differentiation (because networks
are characterizedby different machine
locations). These characteristics are asso-
ciatedwith weak incentives to compete on
price. Competition among networks with
exclusionary practices or rules is product-
based competition; this type of competi-
tion can be inefficient.
SurprisingLy cobranding and duality
can work to reduce this inefficiency by
lowering the high costs of changing
networks and of location-based product
differentiation. By offering banks the
opportunity to,join both of two networks
that compete, consumers need not change
banks to change network usage patterns.
Moreover, by giving consumers access to
all of the facilities in the two networks,
product differentiation is reduced and the
need to compete by product differentia-
tion is lessened. This can lead to greater
incentives forprice competition between
the networks.
Of course, early in the development
of a system, location-based product differ-
entiation may be welfare enhancing in that
it quickens the development of the system.
However, the greater value consumers
place on a larger network may work to
hasten development without the exclu-
sionary practices. The point that I wish
to drive home is not that exclusionary
rules are in all cases bad,hut rather that
exclusionary rules can be used to reduce
price competition.
The proponents of systems competi-
tion—and Donald Baker and David Balto
have been eloquent advocates of the effi-
ciency of systems competition—have argued
that it is vital to maintain systems competi-
tion. I believe that equal emphasis must he
given to determining what type of competi-
tion flourishes under exclusionary rules.
The evidence that Carlton and FrankeL
present on the effects of the entry of AT&T
and GM in the credit card market is com-
pelling. They find significant decreases in
both the average annual fees charged by Visa
issuers and in credit card interest rates after
the entry of AT&T and GM, which suggests
that the performance of the credit card
market was not competitive, despite its
competitive structure. Calem and Mester
(1995) investigate several hypotheses that
might account for the results of Carlton and
Frankel. One such hypothesis is that there
are substantial costs borne by a consumer
when switching credit card providers. A
consumer’s history with a credit card issuer
can lead the issuer, ifthe consumer is credit-
worthy to grant the consumer high credit
limits. This information is private and
induces a switching cost: the consumer
cannot obtain such generous credit limits
elsewhere. So an issuer that lowers its
rates will tend to attract less creditworthy
borrowers—an adverse selection problem.
Ausubel (1991) and Calem and Mester
(1995) find significant divergence in perfor-
mance of the credit card industry from its
competitive structure.
CDLLECT1YE RESTRAINTS
Collective restraints in paytnent sys-
tems can include restraints on competition
in related markets, that is, tie-ins, in addi-
tion to outright exclusion from partici-
pation. The Department of,Justice, in its
complaint against EPS and its MAC net-
work, allegedthat EPS engaged in tying its
ATM processing to its provision of branded
network access.
Another way tie-ins can yield an
advantage to the owners of a payment
system is discussed here. Consider a pay-
ment system with access associated with a
logo and transactions processing. Suppose,
furthermore, thac because of the economies
of ubiquity there is a monopoly in the
access market; processing, however, is an
activity in which there are no inherent
FEDERAL RESERVE BANK OF St. LOUIS
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NDVEMBEE/DECEMSER ‘995
scale advantages. Then a payment system
operator could tie the sale of processing to
the sale of access, in which it has a domi-
nant market position.
A monopoly access provider would
not necessarily gainby tying processing to
access because of reduced sales. However,
in the case of a bank holding company
joint venture that competes in the down-
stream retail banking market against cus-
tomers of its system, the joint venture has
another margin it can exploit. By tying
the sale of processing to the provision of
access, thejoint venture can raise the
processing fees above the level of cost.
Accordingly prices for the service in the
retail market will rise to match the level of
the transaction fee because these fees are
usage sensitive.
Providing access, on the other hand,
does not entail, to the extent that process-
ing does, a usage-sensitive cost. Pricing
for access then usually takes the form of
card-based and machine-based fees or
monthly fees. These fees are less transac-
tion sensitive, and therefore we would not
expect them to be translated into con-
sumer pricing at the point of the transac-
tion, hut rather would expect them to he
included in yearly checking account fees,
a lower checking account interest rate or
higher minimum checking account bal-
ances, Hence by tying processing to
access, the joint venture gains control of a
usage-sensitive cost that affects pricing to
the ultimate consumers,
Tyingprocessing to access allows
the joint venture to raise rivals’ costs by
setting the processing fee above marginal
costs. Salop and Scheffman (1983) show
that raising rivals’ costs allows one to
gain competitive advantage over rivals.
The average cost to thejoint venture’s
affiliate banks is not affected as much
because profits flow to the bank holding
company owners and can be allocated
to the affiliate banks. Hence the affiliates
of the owners gain an advantage in the
retail marketplace, over and above
the profits that accrue to the owners of a
successful regional brand or logo for
network access.
This suggests that networks whose
owners are all in-market would have a more
limited incentive to exploit this margin to
raise rivals’ costs, whereas a network whose
owners had little banking market overlap
would be more apt to exploit this incentive
to tie a processingservice to an access
monopoly
This model would also suggest that the
retnedy that EPS and the Department of
Justice agreed to in their consent decree—
which was to allow competition in ATM
processing—was appropriate. Tying the sale
of any processing to system access should
concern antitrust authorities, especially
when the owners of the system compete in
the retail market.
The effects of collectively set inter-
change fees, duality and collective restraints
on membership and associated products
differ depending on the nature of competi-
tion among competing systems and
depending on competition in the down-
stream retail banking market. In general,
the features of the payment products that
I’ve discussed in this talk, including net-
work externalities in demand, high costs
for consumers (or merchants) to change
systems under exclusionary rules, oppor-
tunistic vertical integration and competi-
tion in product differentiation rather than
in price, all suggest that the nature of sys-
tems competition is likely to he far from the
perfectly competitive ideal and that anti-
trust policy will play an important continu-
ing role in this industry Furthermore, the
results of research on duality and cobrand-
ingin credit card networks and in ATM and
POS networks, both from an empirical and
theoretical viewpoint, suggest that these
interconnection agreements can manage
both to reduce the imperfections of systems
competition under exclusivity agreements
and to extend the benefits of network
externalities in demand.
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Kaupe~ Thomas, E. “Opinion of Arbitrator Thomas F. Kouper in Re-
Arbitration Between First Texas Savings Association and Financial
Ausubel, Lawrence M. “The Failure of Competition in the Credit Card Interchange, Inc.,” The Bureau of National Affairs, Inc.,
Market,” The ,4rnericon Economic Review (March 1991), pp. August1988.
50—81. Solop, Steven C., “Deregulating Self-Regulated Shored ATM Networks,”
Baxter, William F, “Bank Interchange of Transactional Paper: Legal and Economics ofInnovation and New Technology (January/February
Fconomic Perspectives,” Journalof Low andEconomics (October 1990, vol. 1), pp. 85-96.
1983), pp. 541-88. and D. Scheffman, “Raising Rivals’ Costs,” The American
Calem, Paul S., and Loretto I. Mester. “Cansumer Behavior and the Economic Review, Papers and Proceedings (May 1983),
Stickiness of Credit Card Interest Rates,” TheArnericon Economic pp. 267—71.
Review (1995). Spohç Walter E. The Clearing and Collection of Checks. The Bankers
Cannon, James G. Clearing-Houses. D. Appleton and Co., 1908. Publishing Co., 1926.
Canton, Dennis W., and Alan S. Irankel. “The Antitrust Ecanomics of
Credit Card Networks,” Antitrust Law Journal (Winter 1995),
pp. 643—68,
Gilbert, Richard J. “On the Delegohon of Pricing Authority in Shared
Automatic Teller Machine Netwarks,” in Margaret F. Gterin-Colvert
and Steven S. Wildman, eds. Elechonic Services Networks. Praeger,
1991.
Kauffman, Robert I., and Yu-Ming Wang, “Growth Patterns and Regime
Change in NafionolF~Shored Flectronic Banldng Networks: Mi
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FEDSIAL RESSSVE BANK OF St. LOUIS
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Antitrust and payment technologies: commentary

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Antitrust and payment technologies: commentary

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