Payments system regulation: the bigger picture
Expert industry communities have a tendency to get caught up in the details of their own sub-segment of the economy. Dealing with the complex and specialised details of their particular activities, they can often overlook that structural controversies arising in the industry have almost always been met before, in some other industry. With this in mind, it is instructive to put current debates on Australian card payments system regulation in a broader context: what can we learn from outside the Australian payments industry?
The major regulatory focus in card payments in 2008 is on the 2007/2008 Payments System Review. This addresses the effect of regulatory reforms of the Australian card payments system introduced by the Reserve Bank (RBA) progressively from 2003, taking into account available evidence of the reforms’ effect, extensive industry submissions and debate. The reforms cover:
- access seeking to ease the path for new industry entrants by making access to card payments infrastructure more transparent and objective;
- disclosure seeking to provide more information about competing services in the system so as to promote competitive markets;
- removal of merchant restrictions mainly comprising changes to merchants obligations to honour all cards, and to their ability to surcharge card transactions; and
- interchange fee regulation which sets a cap, or a capping formula, on interchange fees for various products.
To generalise, the RBA’s paper reaffirms the RBA’s commitment to ongoing oversight. It finds that reforms relating to access, disclosure and merchant restrictions have been beneficial and should be retained and, in some specific respects, extended. However, the treatment of interchange fee regulation is quite different. The RBA’s Payments System Board indicates a preference for removing direct regulation of interchange fees, on certain conditions designed to increase competitiveness in choice of payment instrument.
APCA, along with much of the payments industry, has strongly endorsed the underlying philosophy of promoting competition as the road to system efficiency. However, it might be suggested that the RBA paper contains a kind of ambivalence. There seems to be some doubt as to whether it is possible for competitive markets to achieve the desired policy result of system efficiency. In addressing this doubt, much can be learned from Australian industry policy experience outside the payments industry.
Australian competition policy
In 2005, the Organisation for Economic Cooperation and Development praised Australia for:
"…the tenacity and thoroughness with which deep-seated structural reforms were proposed, discussed, legislated, implemented and followed-up in virtually all markets, creating a deep-seated ‘competition culture’. "
At around this time, Australia enjoyed per capita GDP and productivity growth that was the envy of the developed world. In a recent speech, the chairman of Australia’s Productivity Commission, Gary Banks, said that this strong performance was a direct consequence of two waves of pro-competitive microeconomic reform that gathered pace from the 1980’s.
From this economy-wide perspective, competition works; it works across many industries, in many different contexts, and for the long term. Competitive markets are the best means we have so far found to increase productivity, promote industry growth and innovation, and ultimately, enhance community wealth.
In the regulation of large complex markets, there is often a two-step process. First, minimum public policy requirements (such as consumer protection and financial stability) must be met whether or not the market is functioning competitively. But once this has happened, the ongoing promotion of efficiency, innovation and market development is seen as a function of competitive markets. In pursuit of these market development goals, regulatory intervention is justifiable only on the basis of market failure, and then only when regulation can reasonably be expected to address the failure efficiently. As stated by Gary Banks recently:
"Market failures are pervasive, but in order for them to become a rationale for intervention (‘policy relevant’) they need to be substantial and amenable to government action, without giving rise to even larger costs…"
So far, we in Australia have not yet found an industry segment where competition cannot be made to work as the driver of productivity, innovation and growth. Consider gas pipelines and railways through the desert, broadband telecommunications, grain marketing into global markets, and electricity generation to meet long-term future needs, to name just a few recent newsworthy examples. Each one has presented daunting challenges to competition policy: huge investment risk, political risks around the protection of local producers, huge economies of scale and much greater network effects than anything we experience in the payment system. And yet in all these sectors, the consistent debate is not about whether the market can work: it is about how we can make the market work.
The case for permanent price controls is usually only made when there is, in effect, only one set of train tracks: that is, basic infrastructure needed by all competitors is controlled by one or a few of them, and for various reasons it is simply not possible to duplicate it. A recent example is a mine railway carrying ore to port from an isolated mining area. In those circumstances, access to the railway may need to be mandated to all competitors on fair terms. But, at least since the RBA’s earlier reforms, that is not the problem in payment services. There are several sets of tracks, and much lower barriers of entry to set up new ones.
From the broader perspective of infrastructure reform, it is difficult to see price regulation as a permanent solution. As the National Competition Policy articulated, whatever their benefits to businesses and consumers, the long-term effect of all forms of price regulation is to dampen competition by reducing incentives on market participants to respond to pricing signals. If we are really committed to long-term payments industry health and growth, promotion of payment industry competition seems to be a necessity.
Waves of competition policy reform
Outside the payments system world, competition policy reform has gone through multiple waves. In each wave, the transitional pain was apparent pretty quickly, but eventually dissipated. The longer term economic benefits took longer, were less obvious, but have been both substantial and enduring.
The first wave might be called “trust-busting” and arose as a response to the less attractive side effects of the first great era of globalisation before the First World War. In the early part of the 20th century, governments developed rules to prevent monopolistic abuses of market power such as those exhibited by the early railway barons in the United States.
Later, there was a cycle of broadly based competition reform around the introduction in Australia of the Trade Practices Act of 1974. This led over a period of years to a re-examination of many long-standing industry practices that were not intentionally anti-competitive, and had origins in quality standards and process efficiency. Cumulatively, however, these caused a drag on innovation and economic efficiency.
An example is stockbroking: in the 70’s and early 80’s, the Australian broking industry dismantled a hundred years of stock exchange practices such as black-balling new members, fixed broker commissions, broker sponsorship of new listings and so on. Around the same time, share trading became nationally automated, pooling liquidity from six state exchanges and opening state-based broker communities to national and ultimately international competition. Without those often painful changes Australia would not have the kind of vibrant, globally competitive national stock market we take for granted today.
The next wave of reform took place in the 80’s and 90’s. It focused initially on opening the Australian economy to global markets and subsequently on opening Government and utility services to competition. Obvious examples are the deregulation of financial markets, the promotion of competitive markets in telecommunications, and more recently energy supply and distribution. These sustained efforts were outstandingly successful over the long term, as the productivity analysis referred to earlier attests; but there was substantial transitional pain and dislocation. For example, consumers enjoyed greater choice and flexibility, but often faced higher prices, and greater complexity.
In 2005, the Productivity Commission concluded that:
"National Competition Policy (NCP) has delivered substantial benefits to the Australian community which, overall, have greatly outweighed the costs. It has:
- contributed to the productivity surge that has underpinned 13 years of continuous economic growth, and associated strong growth in household incomes."
There are two observations to draw from this brief history. First, competitive efficiency reform is unfortunately not simply a matter of letting the market sort it out; thought and effort is often required to promote effective, competitive market structures and then deal with the usually complex transitional issues that will arise. Secondly, industries, particularly complex networked ones, always take substantial time to respond to such significant structural change. The new market signals need to feed through the various industry linkages, new types of competitors need to emerge, technology needs to develop to fill new structural opportunities.
Payments policy challenges
If we apply this to payment systems, a difficulty in assessing the reforms since 2003 is that several different competition promoting reforms, such as changes to merchant restrictions, access improvements and increases in transparency, came in progressively alongside interchange fee regulation. Whatever one’s views about the merits of the various reforms, this complicates the assessment of reform efficiency: If there is an efficiency benefit, which reforms caused it?
There was certainly transitional pain and dislocation. This took the form of several court cases, some Government inquiries, and quite a bit of industry debate and controversy until industry repricing and other strategies emerged as a response to structural reform. In accordance with its commitment to the industry, the RBA began review of the total package in 2007, even though less than four years had elapsed from the first reforms.
Relying on the experience in infrastructure reform, this is not giving the market much time to respond. Structural change to increase competition takes time to flow through market eddies, competitive responses, market repositioning and ultimately, efficiency gain.
Nevertheless, by April 2008 the RBA was able to conclude that “the reforms have met a key objective of improving price signals consumers face when choosing between use of credit and debit cards”.
In particular, the RBA’s analysis of surcharging shows remarkable market response to the pro-competitive elements of the total package. The evidence presented in the RBA paper suggests that competition in payment instrument markets is substantial, and increasing. No doubt this is partly a consequence of the reforms, but also of substantial structural evolution as well. Given the short timeframes compared with competition reform in other sectors, it’s hard to assess right now how much more needs to be done to enhance these positive trends.
It is very important for all those involved in the Australian card payments system to think about how to future proof the competitive environment. The message from other industries is loud and clear: there is no question that competition can be made to work – the only question is, how best to do it.
APCA believes that there is much to be gained from an active industry dialogue on the state of competition. We need to identify the indicators to monitor, generate some consensus on what we would as an industry regard as satisfactory levels of competition, and if necessary, debate the merits of other pro-competitive measures that could be taken, many of which will not be regulatory in nature.
