The Economics of Interchange Fees and Their Regulation: An Overview

In 1958, Bank of America began operating the BankAmericard credit card system, the predecessor of Visa, as a unitary system. It performed both the issuing function (dealing with cardholders) and the acquiring function (dealing with merchants) itself. Similarly, it set the fees charged to both these customer classes—the annual fee, interest rate, late fees, and other fees charged to cardholders and the per-transaction fee to merchants known as the merchant discount. It was therefore able to determine both the overall level of fees (which might be measured as total fees per dollar of transactions) and their structure (which might be measured by the shares of total fees paid by merchants and cardholders). In 1966, Bank of America began to bring other banks into the system as franchisees. Individual banks within the system were free then, as now, to determine the fees they charged merchants and cardholders. When a consumer holding a card issued by bank A made a purchase at a merchant that had bank A as its acquirer, bank A could, if it wished, have the same fee structure as Bank of America. But what if this same consumer made a purchase from a merchant acquired by bank B? Bank of America required the acquiring bank to pass the full merchant discount to the issuing bank. Acquiring banks had incentives to lie about their merchant discounts under this rule, as issuing banks were well aware. More importantly, this rule meant that acquiring banks received zero revenue for transactions for which they provided the merchant but had not issued the card being used. The rule therefore blunted the incentives for all banks to sign up merchants, to the obvious detriment of the system as a whole. In 1970 the BankAmericard system was converted into a membership corporation, a multiparty system. This cooperative association established an interchange fee in 1971 to deal with transactions in which issuing and The Economics of Interchange Fees and Their Regulation: An Overview