The Debate over Discount Fees Hinges on the Costs for Unsecured Credit
Tom Cleveland, March 22, 2012
The debate over the proper level of merchant discount fees rages on with legal arguments and proceedings plodding along, possibly for years to come. One benefit of the latest struggle against bankers keeping their “hand” in the merchant industry’s “cash drawer” is that fees have been bifurcated between credit and debit cards in the United States, applying a lower transaction based fee to items regarded as true replacements for cash and checks. Whether the banking “monopoly” will be broken remains in doubt, but the real issue is how to recover the total costs related to issuing unsecured credit.
Unsecured credit is more a phenomenon in American culture than in most other global domestic markets. One argument often cited is that discount fees in the U.S. are materially higher than those in other countries, but the nature of credit and how it is offered to the general public is the core issue here. The rest of the world is a lot “harsher” in how credit is extended, but credit drives our service economy that depends heavily on consumer retail spending. Disposable income has remained flat for over a decade, and, until this economic fact changes for the better, the retail sector will continue to under perform.
Intuitively, one would expect these merchant fees for card services to be entirely transaction based, without a percentage of the sale ever having to be reimbursed to card issuing banks. Unsecured credit, however, does not come without a significant cost structure. The “rule of thumb” for individuals and companies alike is that a total revenue stream of 35% on volume is necessary to operate at an acceptable level to cover costs and deliver an adequate return on capital. Interest charges cover two-thirds of this requirement, but additional fees are necessary to cover convenience usage where no interest can be charged. Roughly half of retail purchase volume constitutes convenience usage in the card services industry.
The remaining third comes from account fees, merchant discount fees, and a plethora of various fee types foisted on the general public over the years. Consultants advised banks decades ago to broaden their revenue base beyond interest-only charges to remain competitive, and we have all witnessed this “transformation” in “nickel-and-diming” tactics for years.
The costs for unsecured credit are actually higher today, due to present economic conditions, but may moderate over time, although not below the 35% threshold. If merchant discount fees are to drop, then banks will have to raise account fees, almost doubling current levels to cover the difference. There is no “free lunch” in this business. Banks are currently under pressure from toxic mortgage assets, new legislation, and debit card fee reductions. They have no desire to introduce new consumer fee changes, as many major banks have tried and failed with this approach recently.
Banks have fought merchant fee reductions for decades, due to unsecured credit costs. The courts may eventually have to force the issue, necessitating a re-pricing exercise that will unfortunately impact us all in other ways.