Finance people only

FIN 5567/369 Keeton Spring 2015

Outline of Unit 5: Credit Cards

Note: Starred items are for graduate students only.

. A. Summary of key characteristics

1. Types of transactions: both card-present (POS) and card-not-present (online or over telephone) 2. Average transaction size: higher than for cash or debit cards but lower than for ACH 3. Clearing and settlement: Unlike checks and ACH, there is not a direct transfer of funds from payer’s bank account to payee’s bank account 4. Period over which credit can be extended: Till end of billing cycle for charge cards but longer for credit cards. 5. Finality: Unlike ACH credits and wire transfers, payments are not final

--By law, card holder can reverse payment for fraud or for failure of merchant to deliver promised goods and services.

6. Interchange fees: Unlike methods studied in first half, interchange fee is paid by payer’s bank to payee’s bank (in open-loop model) f. Time of settlement: Takes a day or more (not real-time)

B. History 1. Store charge cards: could only be used at one store or chain of stores 2. Diners Card (1949) --Closed-loop system

--First travel and entertainment (T&E) card: started in New York and eventually became national

--Was a charge card rather than credit card (bill had to be paid each month) --Unlike the store charge cards, could be used at multiple businesses

--Diners Club earned revenue mainly from 7% fee paid by merchants (example of a two-sided market with merchants subsidizing use by consumers)

--Benefits to merchants: Payment quicker and more certain than with checks 3. American Express (1958) --Closed-loop system

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--Introduced because its travelers checks were losing out to Diners Card --Had higher annual fee for customer but somewhat lower merchant charge --Eventually beat out Diners Card 4. BankAmericard/Visa (1958) --Started in California as a closed-loop system

--Did a mass-mailing of cards that got consumers on board but produced big credit and fraud losses

--Revenue model: Like Diners Card and AmEx, charged merchants a percentage fee. But unlike Diners Card, allowed customers to delay payment, for which it charged interest (this type of loan is called revolving credit).

--Went national in 1966 by franchising card to banks in other states (BofA did not have its own branches in other states because of interstate banking restrictions)

--Beginnings of open-loop system: a merchant that signed up with one franchisee bank had to accept cards issue by any another franchisee bank

--Benefit to franchisees: BL say it was mainly interest on credit card balances (?) --Complaints of franchisees: wanted to promote their own names instead of BofA’s

and wanted more say in network’s future --Franchise model changed to “co-opetition” model in 1970: bank-owned

association with rules and processes for settling transactions (banks competed with each other for merchants and card holders but cooperated on processing)

--Interchange fee was set by association to avoid the chaos of each bank having to negotiate the fee with each merchant.

--Association changed name to “Visa” in 1976 --A huge advance not discussed by BL or ES: the introduction in 1973 of the

“switch” (national computer network for real-time authorization of payments) --Visa public in 2008 (it’s now a corporation owned by shareholders)

5. Interbank Card/Association/MasterCard (1966) --Similar history to Visa except that it began as a regional association of banks instead of closed-loop system operated by one bank. --Went public in 2006

C. Business models for credit and charge cards

1. Closed-loop vs. open networks

--Closed loop (American Express and Discover): a single company makes payment to merchant and collects payment from card holder

--Open-loop networks (Visa and MasterCard): one group of banks (issuers) make

payments on behalf of card holders, while another group of banks (acquirers) collect payments on behalf of merchants

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2. Pricing

--Closed loop: Merchant pays percentage fee to card company on each transaction. Consumer pays annual card fee to card company.

--Open-loop: For each transaction, merchant pays percentage fee to acquiring bank

(known as merchant discount). Acquiring bank then pays interchange fee to issuing bank. Issuing bank may collect annual fee from card holder but often pays percentage reward on each transaction (like a negative transaction fee). Network collects a small percentage transaction fee (called network fee) from each of the banks.

2. Issuing function in an open-loop card network

--Card holder often does not hold checking account at the issuer --Some banks called monolines specialize in issuing and servicing credit cards --Revenue model: issuers get revenue from interest on credit card balances,

interchange fees, and annual card fees, in that order. Annual card fees have fallen due to competition among issuers for card holders.

3. Acquiring function in an open-loop card network

--Merchants often contract for acquiring services with a processor, but there must

always be an acquiring bank in background with contractual responsibility. --Brokers called ISOs help connect smaller merchants with acquirers. --Competition among acquirers is intense, resulting in low spread between

merchant discount fee and interchange fee. --Visa and MasterCard have let companies like PayPal and Square serve as a

“master merchant” or aggregator for smaller merchants so they don’t have to line up their own merchant accounts.

D. Processing of credit card payments: authorization, clearing, and settlement

1. Authorization --Acquiring bank or processor sends message to issuing bank to verify that card is

legitimate and payment is within card holder’s credit limit. --Authorization occurs in real-time (is immediate)

2. Clearing

--At end of day, information on card payments is batched and sent for clearing through the card network.

--Dual-message system: clearing message is separate from authorization message.

3. Settlement

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--Funds are transferred from issuing bank to acquiring bank via card network’s

settlement bank. --As in check payments, issuing banks ends up with higher reserve balance at

Federal Reserve and acquiring bank with lower balance. --Issuing bank increases amount due from card holder. Acquiring bank credits

bank account of merchant.

E. Credit card use in U.S. vs. other countries

1. Credit card use is greater in U.S. than in most other developed countries 2. Possible reasons

--Large geographic size of U.S. meant more payments were made by business travelers from distant locations.

--Fragmented banking market prevented acceptance of checks from distant locations (they were drawn on small unknown banks instead of branches of large well-known banks)

--So an alternative to cash and checks was more needed in U.S.

F. Controversy over interchange fees

1. Arguments that interchange fees are appropriate (Evans and Schmalensee)

--ES argument about pricing in a two-sided market: The benefit of using cards rather than cash and checks is greater for the merchant than for the consumer, making it efficient for merchants to subsidize card use by consumer (by paying high interchange fees that card issuers can use to cover their costs and pay rewards to card holders).

--*ES evidence on Visa/MC interchange fee ceiling in Australia: They say effect was to decrease cardholder benefits and cause issuers to switch to AmEx.

2. Arguments that interchange fees are too high (Carlton, Mott)

--Market power argument: Because Visa and MasterCard dominate the market, card issuing banks can collude to set interchange fees at monopolistic levels.

--Private vs. social benefit argument: Merchants put up with high interchange fees only because accepting credit cards keeps their customers from switching to other merchants who accept credit cards (a private rather than social benefit)

--*Mann cross-subsidization argument: Merchants raise prices for all consumers to cover the interchange fees, resulting in subsidization of card users (who get generous rewards from their bank) by cash users (who tend to be poor).

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--*Case for surcharges: If merchants benefit more from credit card use than consumers, we should let them impose surcharges on other payment methods rather than making them pay high interchange fees on credit cards.

--*Evidence on interchange fee ceiling in Australia: Carlton says there was no decrease in Visa/MC charge volume relative to AmEx. (This is from article by Carlton assigned for Unit 6.)

*3. Legal and regulatory battles

--NaBanco v. Visa (1979): Court supported Visa’s argument that interchange fees

were justified because of the two-sided nature of card industry --Reserve Bank of Australia (RBA) : Rejected Visa’s argument about two-sided

nature of card industry and imposed cost-based ceilings on credit card interchange fees

--Supporters of interchange fees say ceilings in Australia were harmful (Evans and Schmalensee), while opponents say there were not (Carlton).

G. Credit risk

1. Risk to issuing banks: Card holder could default on amount owed to bank

--Card issuers manage this risk by doing credit checks on consumers applying for a card and establishing credit limits.

--Growth of credit bureaus and advances in credit scoring have facilitated such credit checks.

2. Risk to acquiring banks: Card holders could default on the amount owed to the bank issuing the card

--Card issuers manage this risk by doing credit checks on consumers applying for a card and establishing credit limits.

--Growth of credit bureaus and advances in credit scoring have facilitated such credit checks.

3. Risk to consumer: Merchant could go out of business after accepting payment but before delivering goods.

H. Fraud risk and allocation of losses

1. Types of credit card fraud

--Fraudster steals card and uses to make card-present payments. --Fraudster steals card information, uses the information to makes a counterfeit

card, and uses the counterfeit card to make card-present payments. --Fraudster steals card information and uses it to make card-not-present payments.

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--Fraudulent merchant accepts credit card payment with no intention of delivering the promised good.

2. Allocation of liability for credit card fraud

*--Public law: Truth in Lending Act (TILA) and Reg Z limit liability of cardholder to $50 with no time limit on report of loss, leaving card issuer responsible for greater losses

--Card network rules: Eliminate all liability of card holder and allow card issuer to shift liability to merchant in specified conditions. Acquiring bank is ultimately responsible for merchant.

--Result is to make card issuer liable for most card-present fraud (merchant only has to show a signed receipt) and leave the merchant liable for most card-not- present fraud.

--Acquiring bank is responsible for merchant, so if merchant goes bankrupt or is a fraudster himself (i.e., doesn’t deliver the good), acquiring bank takes the loss.

--*These rules may have adverse effects on incentives of consumer, card issuer, and merchant to prevent fraud.

3. Dispute resolution

--When card holder alleges payment was not authorized or promised goods were not delivered, issuer requests that acquiring bank return payment (called a chargeback).

--Acquiring bank can dispute chargeback on behalf of merchant, leaving it to network to resolve.

4. Early methods of fraud prevention

--Checking signature on receipt against signature on back of card: prevents

fraudster from using a stolen card to make a card-present payment (but merchants rarely did this)

--Encoding of CVV or CVC in magnetic stripe: prevents fraudster from using information on paper receipt to make card-present payment with counterfeit card

--Addition of CVV2 and CVC2 (3-digit number) to back of card: prevents fraudster from using stolen card number to make card-not-present payment

5. Newer methods of fraud prevention

--Chip cards with signature verification: prevents fraudster from using a card

skimmer to copy information on card and make counterfeit card --Chip cards with PIN: prevents fraudster from stealing card and using it to make

POS purchases (because he would need to know the PIN) --Why merchants are finally installing Chip card terminals: After 10/15/15, Visa

and MasterCard will make merchant liable for fraudulent purchases from traditional terminals

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--Merchant data breaches: Chip cards don’t prevent breaches because cardholder data is not encrypted on merchant computers. Stolen information cannot be used for card-present payments but can be used for card-not-present payments.

--Tokenization: A new technology for encrypting and protecting card holder data. --Apple Pay: uses both tokenization and biometric identification, which is an

improvement over signature and PIN authentication.