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Beyond the very visible interchange fees, accepting credit and debit cards carries less-obvious costs that affect merchants, consumers and society, according to some observers.

"Clearly, interchange rates are a hidden tax on consumers," Michael Cook, vice president and assistant treasurer of Wal-Mart Stores Inc., said last week at a conference on payment card pricing held at the Federal Reserve Bank of Chicago.

Wal-Mart would pass along any savings on processing costs to its shoppers, Cook said. "We pay a billion dollars in credit card and debit card interchange fees. That's a billion dollars that won't be given back to the consumer."

Adam Levitin, an associate professor of law at Georgetown University, said the costs of reward cards are unfairly shared by all cardholders. According to Visa Inc.'s card acceptance rules, merchants that take one type of Visa card have to accept all types, including cards with no rewards, moderate rewards and premium rewards. MasterCard Inc., Discover Financial Services and American Express Co. have similar rules.

"The result is that merchants have to either eat the costs of card transactions or pass them on to consumers," Levitin said. "Users of super-high-level rewards cards are subsidized by those with lower-rewards cards and unbanked cash users. So we have a very regressive subsidization system coming out of card networks."

The Consumer Federation of America agrees with that assessment.

"All the low-income consumers who pay with cash or checks or plain vanilla credit cards are subsidizing your miles," said Jean Ann Fox, the federation's director of financial services.

She estimated that merchants paid processors $48 billion of interchange last year. "This is a transfer of wealth from those who don't benefit from rewards cards to those who do."

Few consumers understand what interchange fees are and that they ultimately cost consumers in higher store prices, Fox said.

But the National Retail Federation has been using the cost-to-consumers argument for years in its lobbying for laws that would give merchants more power to bargain with card networks and acquirers over card acceptance fees.

Mallory Duncan, the trade group's senior vice president and general counsel, said that Fox's estimate of $48 billion for processing costs industrywide comes to $427 for each household. "If I came to you and said, 'You can have this card, and it will only cost you $427 in hidden fees,' how many consumers would want it?"

However, card company executives questioned assertions that lower interchange rates would translate into lower prices for consumers.

"Merchants saying, 'I can't pass along any cost, but I'll pass along savings,' that always fascinates me," said Joshua Peirez, MasterCard's group executive for innovative platforms.

Merchants also argued that interchange fees cost jobs.

"Our interchange fees are our third-largest cost, behind rent and salary, ahead of health care," Dwayne Kimmet, the vice president of financial services for Home Depot Inc., said during a presentation at the Chicago Fed conference. "Our interchange costs are increasing through a few areas: new, higher-cost … rewards, increasing costs of debit, increasing chargeback rates and the introduction of new association fees."

If card acceptance costs were lower, Home Depot might pass some of those savings to shoppers, but it would be more likely to use the funds to hire 10 more associates per store, Kimmet said.

But Peirez argued that, given the costs issuers and networks shoulder for chargeoffs and card fraud, merchants come out ahead.

"In 2006 the average interchange fee in the MasterCard system was 1.81% [of transaction amounts], versus average credit losses of 2.41%," he said. "Right there alone is a 25% better value, not counting any of the other costs."

Levitin argued that interchange income for card issuers also has fed dysfunctional credit use, because interchange helps offset losses from credit card chargeoffs.

The higher the interchange rate, the more aggressively issuers can afford the risks of lending, "so transactors essentially are subsidizing revolvers and defaulters," he said. "Riskier underwriting enables greater card penetration, and that enables greater interchange revenue, and at some point, the system starts to break down."

But Peirez says interchange also helps fuel innovation for new products and services that card networks and issuers can offer merchants and consumers.

"I believe in free markets, and I believe in free pricing as the main component of free markets," Peirez said. "If you think prices are too high, that provides opportunities for the Tempos of the world and the PayPals of the world to come in and offer a better value. Merchants should innovate rather than regulate."

Tempo Payments Inc. and eBay Inc.'s PayPal offer alternative payment options to traditional bank cards, often at a lower cost to merchants.

But innovation is not always good for consumers, Levitin said. He cited introductory teaser rates for credit cards as an example.

"For some consumers, that can be a wonderful thing. But Providian wasn't borrowing money at 3% to loan it out at 0%," Levitin said. "The model was premised on consumers screwing up."

Providian Financial Corp. was acquired by Washington Mutual Inc. (now JPMorgan Chase & Co.) in 2005.

David Stewart, a Chicago senior expert at the consulting firm McKinsey & Co., said that the cost of card acceptance provides an opportunity for lower-cost payment system vendors. Though signature debit card use carries a cost of 61 cents per transaction, cash carries a "societal cost" of 6 cents, Stewart estimated.

"The market is innovating and finding ways to fill that gap, I think, ultimately, to the benefit of society," he said.

Stewart's estimate of the societal cost is a matter of debate, with card network representatives such as Peirez arguing that costs such as theft, loss and handling add up to far more than 6 cents per transaction.

But according to Fox, cash carries with it one tangible benefit for society. "With cash, you can't go into debt," she said. "It's safest for consumers to use."

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