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2007
This paper presents the initial results of a joint study undertaken by
staff at the European Central Bank and the Federal Reserve Bank of Kansas
City to document and analyze nonbanks in the payments system. The focus is
on electronic (non-paper) retail payment services in the European Union and
the United States. The results show that nonbanks are making their presence
felt at all stages of the payments chain. And, at this time, nonbanks appear
most prominent in the United States, but are prominent in many European
countries as well. And, most importantly, nonbank presence appears to be
increasing in virtually all countries.
By Members of the European Central Bank Oversight
Division and Members of Federal Reserve Bank of Kansas City Payments System
Research Function
This paper documents the importance of nonbanks in retail payments in the
United States and in 15 European countries and analyzes the implications of
the importance and multiple roles played by nonbanks on retail payment
risks. This paper also reviews the main regulatory safeguards in place, and
concludes that there may be a need to reconsider some of them in view of the
growing role of nonbanks and of the global reach of risks in the electronic
era.
By Members of the European Central Bank Oversight
Division and Members of Federal Reserve Bank of Kansas City Payments System
Research Function
Note: An abridged version of this paper
is also available (PDF
244K)
2006
This paper provides a new theory to explain
empirical puzzles regarding credit card interchange fees. Our model
departs from the existing two-sided market theories by arguing card
adoption externalities are less important in a mature card market.
Instead, we focus on card issuer entry, elastic consumer demand and
the role of card transaction value. Our analysis suggests that card
networks demand higher interchange fees to maximize member issuers’
profits as card payments become more efficient and convenient. At
equilibrium, consumer rewards and card transaction values increase
with interchange fees, while consumer surplus and merchant profits may
not. Based on the theoretical framework, we discuss pros and cons of
policy interventions.
By Zhu Wang
This paper examines how competition among payment card
networks—three-party scheme networks and four-party scheme networks—affects
pricing as well as the welfare of various parties. A competing network has
an incentive to provide rewards to its card users. By providing more
generous rewards than its rival networks, the network can increase its own
card transactions because multihoming cardholders—who hold multiple
networks’ cards—choose to use its card instead of using its rivals’.
Although a monopoly network does not have such an incentive, in a monopoly
four-party scheme network, competition among card issuers likely makes
issuers provide rewards. Due to rewards, the merchant fees under competition
can be higher than the merchant fees set by a monopoly network, unless the
majority of cardholders are multihoming. Generally, cardholding consumers
are better off under network competition. In contrast, non-cardholding
consumers are better off only when network competition reduces merchant fees
lower than those under monopoly. The results suggest that policies that
simply encourage network competition will likely increase cardholder rewards
but will not necessarily lower merchant fees in the U.S. payment card
market. Several empirical indicators may possibly tell which direction the
U.S. payments system needs to go.
By Fumiko Hayashi
This paper seeks to analyze the effects of payment card rewards programs
on consumer payment choice, by using consumer survey data. The results
suggest that (i) consumers with credit card rewards use credit cards much
more exclusively than those without credit card rewards; (ii) even among
those who carry a credit card balance, consumers with credit card rewards
use a credit card more often than those without rewards; (iii) among
consumers who receive credit card rewards, those who receive credit card
rewards as well as debit card rewards tend to use debit cards more often
than those who receive credit card rewards only; and (iv) reward card
transactions seem to replace not only paper-based transactions but also
non-reward card transactions.
By Andrew Ching and Fumiko Hayashi
In this paper, Zhu Wang and James McAndrews provide
a new theory for two-sided payment card markets, which explains both
cross-section and time-series patterns of card pricing, adoption and
usage. Their findings suggest that privately determined card pricing,
adoption and usage tend to deviate from the social optimum, and
imposing a ceiling on interchange fees may improve consumer welfare.
By James McAndrews and Zhu Wang
Nonbank providers of payment services are important in the
United States and appear to have become more prominent in recent years. This
development, by itself, poses unique risks to the payments system.
Associated with this change is a significant transformation in the mix of
payment types away from checks and towards electronic payments, which
introduces new risks to the payments system and potentially compounds the
risks posed by increased reliance on nonbank providers of payment services.
This paper reviews these recent developments in the retail payments system,
discusses the associated risks, and presents an overview of the supervision
of nonbank providers of payment services. Policies aimed at controlling risk
in the retail payments system need to better address an increasing level of
information asymmetries, externalities, and coordination problems. Policy
tools such as standards setting, disclosure, clarifying legal
responsibilities, and supervision can each play a role in improving control
of payments system risk. To guide policy reforms, it would be useful to
collect more information on the sources, extent and cost of disruptions to
payment systems associated with nonbank payment providers.
By Richard J. Sullivan
2005
This paper studies endogenous diffusion and impact of a cost-saving
technological innovation -- Internet Banking. When the innovation is
initially introduced, large banks have an advantage to adopt it first and
enjoy further growth of size. Over time, as the innovation diffuses into
smaller banks, the aggregate bank size distribution increases stochastically
towards a new steady state. Applying the theory to a panel study of Internet
Banking diffusion across 50 US states, we examine the technological,
economic and institutional factors governing the process. The empirical
findings allow us to disentangle the interrelationship between Internet
Banking adoption and growth of average bank size, and explain the variation
of diffusion rates across geographic regions.
By Richard J. Sullivan and Zhu Wang
Pricing in two-sided markets has not been fully understood yet.
Especially, investigations of how competition in these markets affects the
price structure or levels are still underway. This paper takes the payment
card industry as an example of two-sided markets and examines whether two
networks’ competition lowers one of the prices in the industry, merchant
discount fees, and if it does, how much it lowers equilibrium merchant fees
compared with the fee set by a monopoly network. If some cardholders hold
only one card and the other cardholders hold two different cards, whether
network competition lowers the fees and by how much the fees will be lowered
depends on various factors, such as the share of multihoming cardholders in
the total cardholder base, the merchants’ transactional benefit, each
network’s net transactional benefit to its card users, the difference in the
two networks’ cardholder bases, and the share of cardholders in the total
customer base. Numerical examples with various parameter values suggest that
typically, if the share of multihoming cardholders is 20 percent or less, networks
can act as if they are monopolies; and if the share is around 50 percent, the
average equilibrium merchant fee is reduced from the monopolistic merchant
fee by 25 percent.
By Fumiko Hayashi
This paper seeks to provide a bridge between the theoretical and
empirical literatures on interchange fees. Specifically, the paper confronts
theory with practice by asking, to what extent do existing models of
interchange fees match up with actual interchange fee practices in various
countries? For each of four countries—Australia, the Netherlands, the UK,
and the United States—models that “best” fit the competitive and
institutional features of that country’s payment card market are identified,
and the implications of those model are compared to actual practices. Along
what competitive dimensions is there alignment? Along what competitive
dimensions is there not alignment? What country-specific factors appear to
be important in explaining deviations from theoretical predictions? The
results suggest that a theory applicable in one country may not be
applicable in another, and that similar interchange fee arrangements and
regulations may well have different implications in different countries.
By Fumiko Hayashi and Stuart E. Weiner
This paper explains market turbulence, such as the recent dotcom
boom/bust cycle, as equilibrium industry dynamics triggered by technology
innovation. When a major technology innovation arrives, a wave of new firms
enter the market implementing the innovation for profits. However, if the
innovation complements existing technology, some new entrants will later be
forced out as more and more incumbent firms succeed in adopting the
innovation. It is shown that the diffusion of Internet technology among
traditional brick-and-mortar firms is indeed the driving force behind the
rise and fall of dotcoms as well as the sustained growth of e-commerce.
Empirical evidence from retail and banking industries supports the
theoretical findings.
By Zhu Wang
Interchange fees and related issues in credit and debit card
markets have been the focus of considerable attention in recent years. The
academic community has begun to address the economics of these markets.
Public officials have begun to address the policy implications of
developments in these markets. Meanwhile, these markets continue to
experience dynamic change as credit, and especially debit, transactions
account for an ever-growing share of overall payments. This paper provides
an overview of interchange fee developments and issues in a number of
countries. It also presents a preliminary analysis of some possible
contributing factors. The principal conclusion of the paper is that
interchange arrangements vary considerably across countries, and while
existing economic theory provides some insight into fee levels and
movements, much remains to be explained. A number of complex and
interrelated factors, many country-specific, play a role in interchange
developments.
By Stuart E. Weiner and Julian Wright
2004
This paper presents models that explain why merchants accept payment
cards even when the fees they face exceed the transactional benefits they
receive from a card transaction. Such merchant behaviors can be explained by
competition among merchants and/or the effectiveness of the merchant’s card
acceptance in shifting cardholders’ demand for goods upward. The prevalent
assumption used in payment card literature—merchants accept cards only when
their transactional benefits are higher than the fees they pay—holds only
for a monopoly merchant who faces an inelastic consumer demand. A card
network that wants all merchants in a given industry to accept cards sets a
lower merchant fee initially and then gradually increases it to the highest
possible level, which may be higher than the sum of the merchant’s
transactional benefit and the merchant’s initial margin without cards. Such
merchant fees potentially create inequality between cardholders and
non-cardholders.
By Fumiko Hayashi
An industry typically experiences initial
mass entry and later shakeout of producers over its life cycle. It can be
explained as a competitive equilibrium outcome driven by the dynamic
interaction between technology progress and demand diffusion. When a new
product is introduced, high-income consumers tend to adopt it first.
Technology then improves with cumulative output and demand growth generates
S-shaped diffusion as the product penetrates lower-income groups. Eventually
fewer new adopters are available and the number of firms starts to decline.
It is shown that faster technological learning, higher mean income or larger
market size contributes to faster demand diffusion and earlier industry
shakeout. Empirical studies on the US and UK television industries as well
as ten other US industries confirm the theoretical findings.
By Zhu Wang
2003
The payment industry is undergoing significant change. Consolidations
among payment networks and processors have been seen in every payment service area and
technological advances provide incentives for even larger financial institutions to
outsource their transaction processing. As a result, a smaller number of networks or
processors are competing more vigorously for larger financial institutions. In doing so,
volume-based pricing or volume discounts are commonly practiced in the industry. This
paper examines whether the change in fee structure of networks and processors make
community banks’ access to the payment card networks more expensive. Although
community banks pay relatively higher fees per transaction to the networks than their
larger counterparts, their fees per transaction have not increased for most of the payment
services. Processing fees that community banks pay to their processors have likely
decreased. In addition, new processing arrangements have evolved so that community banks
can take advantage of the change in processors fee structure.
By Fumiko Hayashi
Innovations in financial services continuously influence the scope of
financial intermediation and the nature of competition between intermediaries. This paper
examines the optimal exercise of strategic real options to invest in such an innovation,
Internet banking technology, within a two-stage game, parameterized by the distribution of
bank size and uncertainty over the profitability of investment, and empirically tests the
results on a novel data set. Unlike traditional options, in which the distribution of the
future value of the underlying asset is exogenous and the timing of exercise affects only
the return to the option holder, the timing of the exercise of real options in a strategic
context allows the option holder to manipulate the distribution of returns to all players.
The value of the strategic investment option in our model, as a consequence, depends on
both expected future profits as well as the variance of those profits. Expected profits to
an entrant depend, in equilibrium, on its size, as measured by existing market share
(concentration) or total assets, relative to its rivals. Conditional on the degree of
uncertainty, larger banks should, as a consequence, exercise their options earlier than
smaller banks, for purely strategic advantages, and act as market leaders in the provision
of Internet banking services. Like ordinary options, however, the value of the strategic
investment option to both large and small banks increases in uncertainty, implying that
early exercise will be more likely the more information is available about potential
demand. We test these hypotheses on investment in Internet banking services with data from
a sample of 1,618 commercial banks in the tenth Federal Reserve District during 1999.
Evidence indicates that relative bank size, as measured by either market share or asset
size, positively influences the likelihood of entry into Internet banking, and
trend-adjusted variation in income per person (a proxy for uncertainty of demand)
negatively influences the likelihood of entry into Internet banking. In addition, market
concentration of a bank's competitive rivals has a negative relationship with the
likelihood of entering the market for Internet banking services. These relations are
evident in both bivariate analysis and in multivariate logit regression analysis.
By Richard J. Sullivan and David Nickerson
2002
Consumers pay for hundreds of goods and services each year, but across
households and across goods, consumers do not choose to pay the same way.
This paper posits that payment choices depend in part on consumers'
propensity to adopt new technologies and in part on the nature of the
transaction. To test this hypothesis, this paper analyzes consumer's payment
instrument use at the point of sale and for bill payment. The sample
includes consumers surveyed in 2001, who are primarily users of the
Internet. The results indicate that consumers who use new technology or
computers are more likely to use electronic forms of payment, such as debit
cards and electronic bill payments. Particularly, the use of direct deposit
is a significant predictor of electronic payment use. Furthermore, the
results indicate that payment choice depends on the characteristics of the
transaction, such as the transaction value, the physical characteristics of
the point of sale, and a bill's frequency and value variability.
By Fumiko Hayashi and Elizabeth Klee
Nonbanks have always been a key component of the nation’s payments system.
In recent years, however, nonbanks have become even more prominent. This heightened
visibility raises several questions. In which payments activities are nonbanks
engaged? What roles do nonbanks play in specific payments types? What types of
risk are potentially associated with nonbank participation? This paper begins to
address these questions. Preliminary findings include: (1) Nonbanks are involved in a
myriad of activities and roles, both in traditional and emerging payments types; (2)
Nonbank business relationships with banks and other participants in the payments systems
are often highly complex and interrelated; (3) Nonbanks are rarely directly involved in
settlement activities and, hence, appear to be associated with limited settlement and
systemic risk; (4) Both nonbanks and banks appear to be increasingly susceptible to
operational risk factors.
By Terri Bradford, Matt Davies and Stuart E. Weiner
The ATM and debit card industry is undergoing significant change. Some of
the most dramatic changes include the sharp growth in point-of-sale debit card
transactions, the intense competition between online and offline debit, the heavy
consolidation of regional EFT networks and third-party service providers, the
growing importance of nonbank ownership of networks, and new pricing structures and
strategies. This paper provides a guide to the current structure of the ATM and debit card
industry. It also highlights some key economic and public policy issues. Among the issues
addressed are market concentration, vertical integration and economies of scope, pricing,
access, and risk.
By Fumiko Hayashi, Richard Sullivan and Stuart E. Weiner
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