RBA – Page 81 – Digital Finance Analytics (DFA) Blog

Paying For Cards

The RBA published a paper on “The Value of Payment Instruments: Estimating Willingness to Pay and Consumer Surplus” by Tai Lam and Crystal Ossolinski. This paper draws on a survey of consumers’ willingness to pay surcharges to use debit cards and credit cards, rather than cash. Just as the price a consumer is willing to pay for a good or service is indicative of the value he/she places on that item, the willingness to pay a surcharge to use a payment method reflects that method’s value to that consumer, relative to any alternatives.

They find a wide dispersion in the willingness to pay for the use of cards. Around 60 per cent of consumers are unwilling to pay a 0.1 per cent surcharge, which suggests that for these individuals, the net benefits of cards are very small or that cash is actually preferred. At the other end of the distribution, some individuals (around 5 per cent) are willing to pay more than a 4 per cent surcharge, indicating they place a substantial value on paying using cards.

On average, consumers have a higher willingness to pay for the use of credit cards than debit cards. This difference can be viewed as the additional value placed on the non-payment functions – rewards and the interest-free period – of credit cards. They estimate that on average credit card holders place a value of 0.6 basis points on every 1 basis point of effective rewards rebate.

Based on the survey data and information on the costs to merchants of accepting payment methods, they predict the mix of cash, debit card and credit card payments chosen by consumers under different levels of surcharging and explore the implications for the efficiency of the payments system. In particular, the consumer surplus in a scenario where merchants do not surcharge and the costs of all payment methods are built into retail prices can be compared with that where merchants surcharge based on payment costs and retail prices are correspondingly lower. Their findings suggest that cost-based surcharging leads to some consumers switching to less costly payment methods, resulting in greater efficiency of the payment system and an increase in consumer surplus of 13 basis points per transaction.

RBA On Household Risks

In the financial stability report today, the RBA comments:

“Household sector risks continue to revolve largely around the housing and mortgage markets. At this stage, competitive pressures have not induced a material easing in non-price housing lending standards. The composition of new mortgage finance remains skewed to investors, however, particularly in the largest cities. Ongoing strong speculative demand would tend to amplify the run-up in housing prices and increase the risk that prices in at least some regions might fall significantly later on. In the first instance, the consequences of such a downturn in prices are more likely to be macroeconomic in nature because of the effects on household wealth and spending would be spread more broadly than just on the recent property purchasers. However, the further housing prices fall in that scenario, the greater the chance that lenders would incur losses on their housing loans.

At the margin, the recent decline in mortgage interest rates can be expected to boost demand for housing further, although it will also make it easier for existing borrowers to service their debts. Indicators of household stress are currently at low levels, but could start to increase if labour market conditions weakened further than currently envisaged”.

They go on to discuss the APRA and ASIC measures and say it is too soon to assesses their effectiveness. Not, to worry though, as they are “monitoring an array of information”. Too little too late in my view. Actually households are currently more in debt than ever, so levels of stress are in relative terms higher. If rates were to rise, or if house prices fell, the impact would be severe and immediate (in Ireland it took just nine months to wreck household budgets in 2007).

RBA Data On Bank Funding

In the latest RBA Bulletin for the March quarter, there is an interesting article on bank funding “Developments in Banks’ Funding Costs and Lending Rates”. It demonstrates mix of forces in play, including competitive dynamics, relative product pricing, and the impact of the global financial system on the banks. The main finding is that the spread between the major banks’ outstanding funding costs and the cash rate narrowed a little over 2014. This was due to slightly lower costs of deposits combined with a more favourable mix of deposit funding. The contribution of wholesale funding to the narrowing was marginal as more favourable conditions in long-term debt markets were mostly offset by a rise in the cost of short-term debt. Lending rates declined a little more than funding costs, reflecting competitive pressures.

The spread of banks’ funding costs to the cash rate is estimated to have narrowed by about 9 basis points in 2014. With the cash rate unchanged over the past year, the slight narrowing in the spread was entirely due to changes in the absolute cost and mix of funding liabilities. In particular, the narrowing was driven by a lower cost of deposit funding and changes in the composition of deposits. Changes in the costs and composition of wholesale funding (i.e. bonds and bills) contributed only marginally to the fall in funding costs. Nonetheless, funding costs relative to the cash rate remain significantly higher than they were before the global financial crisis in 2008.

Interest rates offered on some types of deposits declined over the year. The cost of outstanding term deposits is estimated to have fallen by about 40 basis points as deposits issued at higher rates matured and were replaced by new deposits at lower rates. Similarly, the major banks’ advertised ‘specials’ on new term deposits fell by about 40 basis points over the past year.

During 2014, the estimated average interest rate on outstanding variable-rate housing loans continued to drift lower relative to the cash rate. The overall outstanding rate declined as new or refinanced loans were written at lower rates than existing and maturing loans. This reflected a sizeable reduction in fixed rates over the year and an increase in the level and availability of discounting below advertised rates. The interest rates on around two-thirds of business
loans are typically set at a margin over the bank bill swap rate rather than the cash rate. While these spreads remain wider, reflecting the reassessment
of risk since the global financial crisis, they have generally trended down over the past two years. Much of the narrowing of spreads over 2014 was due to average business lending rates declining by over 20 basis points, with outstanding rates for small business decreasing by more than rates for large businesses.

RBA Leaves Door Open For More Rate Cuts

The RBA released their Minutes of the Monetary Policy Meeting of the Reserve Bank Board from 3 March 2015. Clearly housing is the potential brake on further cuts, but that said further falls are possible.

In assessing the appropriate stance for monetary policy in Australia, members noted that the outlook for global economic growth had not changed, with Australia’s major trading partners forecast to grow by around the average of recent years in 2015. Lower oil prices were expected to boost growth in major trading partners and reduce inflation temporarily. More generally, although the decline in many commodity prices over the past year had largely been in response to expansions in global supply, members observed that demand-side factors, including the weakness in Chinese property markets, had also played a role. Although the Australian dollar had depreciated, particularly against the US dollar, it remained above most estimates of its fundamental value, particularly given the significant declines in key commodity prices. Conditions in global financial markets remained very accommodative. Changes to the stance of monetary policy by the major central banks were likely to be important influences on financial markets over the coming year.

Data available at the time of the meeting suggested that the Australian economy had continued to grow at a below-trend pace in the December quarter and that domestic demand growth had remained weak overall. There had been some evidence suggesting that growth of dwelling investment and consumption had picked up in the December quarter, but there had also been indications that business investment could remain subdued for longer than had been previously expected. On balance, the evidence suggested that labour market conditions were likely to remain subdued and the economy would continue to operate with a degree of spare capacity for some time. As a result, wage pressures were expected to remain contained and inflation was forecast to remain consistent with the target over the next year or so, even with a lower exchange rate.

At the same time, activity in the housing market had remained strong. Housing prices had continued to increase strongly in Sydney and at a solid pace in Melbourne. In other capital cities, trends had been more mixed and annual increases in capital city housing prices (excluding Sydney and Melbourne) had averaged about 3 per cent. Growth of dwelling investment was estimated to have picked up in the December quarter and was expected to remain at a high level in the near term. While credit had continued to grow a little faster than incomes, household leverage had not increased significantly and the Bank would continue to work with other regulators to assess and contain risks that might arise from the housing market.

Members noted that the current setting of monetary policy had been accommodative for some time and that the recent reduction in the cash rate would provide some further support to the economy. They also acknowledged that a lower exchange rate would help achieve balanced growth in the economy. Nonetheless, on the basis of the current forecasts for growth and inflation, members were of the view that a case to ease monetary policy further might emerge.

In considering whether or not to reduce the cash rate further at this meeting, members saw benefit in allowing some time for the structure of interest rates and the economy to adjust to the earlier change. They also saw advantages in receiving more data to indicate whether or not the economy was on the previously forecast path. Further, they noted the greater degree of uncertainty about the behaviour of borrowers and savers in a world of very low interest rates. Taking account of all these factors, members judged it appropriate to hold the cash rate steady for the time being, while recognising that further easing over the period ahead may be appropriate to foster sustainable growth in demand while maintaining inflation consistent with the target.

Regulatory Changes And The Fixed Income Market

Guy Debelle, Assistant Governor (Financial Markets) gave a speech on “Global And Domestic Influences on the Australian Bond Market.” He covered some of the important up coming regulatory changes.

One global development that has garnered a large amount of comment of late is the effect of reduced market-making capacity in fixed income. The Bank for International Settlements (BIS) Committee on the Global Financial System (CGFS), issued a report on this topic late last year. That report documents the intended effect of regulation in bringing about this reduction. There is a debate as to whether the reduction has gone too far, but the fact that market-making activity is lower than it was pre-crisis is a desirable outcome given liquidity risk was under-priced pre-crisis.

Rather than describing it as a reduction in market-making, I think it is more useful to think of it as a reduction in the risk-absorption capacity of intermediaries. Their ability to warehouse portfolio adjustments of asset managers is curtailed. In the past, asset managers were dealing bilaterally with individual trading desks that each had their own limit. Now these limits are applied holistically across the trading desks so that selling one part of a portfolio to one desk will reduce the capacity to sell another part of the portfolio to another desk in the same institution. Asset managers need to take account of these changes in market dynamics in thinking about how they adjust their portfolios. Transactions costs are higher and, in particular, liquidity costs are higher. I am not sure that all market participants have fully appreciated this yet and are fully cognisant of the impact of the post-crisis changes.

The second development to note is in the asset-backed security space. As many of you know, as of 30 June this year, the Bank will introduce mandatory reporting requirements for repo-eligible asset-backed securities (ABS). The Bank continues to work with the industry to ensure the timely implementation of these requirements. The required information, which must also be made available to permitted users, will promote greater transparency in the market, supporting investor confidence in these assets. These requirements will also provide the Bank with standardised and detailed data on ABS, which are a major part of the collateral eligible to be used under the CLF.

In preparation for the introduction of these reporting requirements and to facilitate industry readiness, the reporting system for securitisations was made available for industry testing in November 2014, with voluntary reporting accepted from 31 December 2014. The Bank is currently working with a number of institutions undertaking test submissions, with some institutions expecting to commence regular reporting shortly. The industry is strongly encouraged to undertake testing early to ensure readiness for the commencement of mandatory reporting on 30 June 2015.

The third development is the proposed changes to the settlement convention to T+2 for over-the-counter (OTC) transactions in domestic fixed income securities. The Bank strongly encouraged this initiative. The current standard of T+3 settlement in the Australian market compares unfavourably with many other jurisdictions that have already progressed to shorter settlement cycles for OTC transactions in their domestic fixed income markets. A shorter settlement cycle will reduce the risks associated with settlement, in particular, counterparty risk. Market makers in OTC fixed income securities may particularly benefit from the reduced period of counterparty exposure, as any given trade will count towards internal credit limits for a shorter period of time. This could boost market turnover and trading capacity for participants. Further, moving to T+2 is likely to encourage straight-through processing, which could reduce the risk of an operational issue affecting the settlement of OTC fixed income securities. Ideally, this would be implemented by the end of 2015.

Stress Testing Households – RBA Paper

The RBA published a Research Discussion Paper “Stress Testing the Australian Household Sector Using the HILDA Survey”. They use data from the Household, Income and Labour Dynamics in Australia (HILDA) Survey to quantify the household sector’s financial resilience to macroeconomic shocks.

Given high household indebtedness, large mortgages and high house prices, estimating the potential impact of changes to interest rates and unemployment are important. Especially so when so much of banks lending is property related, and capital ratios are lower than pre-GFC. DFA of course models mortgage stress in our own surveys, so we have an interest in this work.

Their model suggests that through the 2000s the household sector remained resilient to scenarios involving asset price, interest rate and unemployment rate shocks, and the associated increases in household loan losses under these scenarios were limited. Indeed, the results suggest that, despite rising levels of household indebtedness in aggregate, the distribution of household debt has remained concentrated among households that are well placed to service it. In turn, this suggests that aggregate measures of household indebtedness may be misleading indicators of the household sector’s financial fragility. The results also highlight the potential for expansionary monetary policy to offset the effects of increases in unemployment and decreases in asset prices on household loan losses.

Our perspective is that the household analysis they are using is not granular enough to get at the differential stress across households, and how potential interest rate rises or unemployment will impact. In addition, interest rates are low today, so it is not possible to extrapolate from events in 2000’s. Given the larger loans, adverse interest rate movements will impact harder and faster, especially amongst households with high loan to income ratios. Therefore the results should not be used as justification for further easing of monetary policy.

Some additional points to note:

The stress-testing model uses data from the HILDA Survey, is a nationally representative household-based longitudinal study collected annually since 2001. The survey asks questions about household and individual characteristics, financial conditions, employment and wellbeing. Modules providing additional information on household wealth (‘wealth modules’) are available every four years (2002, 2006 and 2010). So some data elements are not that recent.

As they rely on information from the HILDA Survey’s wealth modules, they had to impute responses to minimise the number of missing responses and thus increase the sample size. The total sample size for each year is around 6 500 households. Individual respondent data were used to estimate probabilities of unemployment; this part of the model is based on a sample of around 9 000 individuals each year. DFA uses 26,000 households each year, our sample is larger.

How then do they estimate potential household stress? Their model uses the financial margin approach where each household is assigned a financial margin, usually the difference between each household’s income and estimated minimum expenses. This is different from a ‘threshold’ approach, where each household is assumed to default when a certain financial threshold is breached (for example, when total debt-servicing costs exceed 40 per cent of income). DFA captures data on the precursors of stress, and models the cash flow changes as unemployment and interest rates move. We also model the cumulative impact of stress which builds over time (typically households survive for 18-24 months, before having to take more drastic action).

Looking at the potential economic shocks, they examined how an increase in interest rates leads to an increase in debt-servicing costs for indebted households, by lowering their financial margins. Interest rate rises tend to increase the share of households with negative financial margins, and thus the share of households assumed to default. Interest rate shocks are assumed to pass through in equal measure to all household loans.

Falling asset prices have no effect on the share of households with negative financial margins. They assume that a given asset price shock applies equally to all households.

A rise in the unemployment rate causes the income of those individuals becoming unemployed to fall to an estimate of the unemployment benefits that they would qualify for, lowering the financial margins of the affected households. Their approach uses a logit model to estimate the probability of individuals becoming unemployed. This means that unemployment shocks in the model will tend to affect individuals with characteristics that have historically been associated with a greater likelihood of being unemployed.

In their most extreme example, households in the middle of the income distribution and renters are the most affected. Households with younger heads are also affected, while household with older heads are not especially affected in any year, suggesting that the increase in indebtedness among these households through the 2000s did not significantly expose the household sector to additional risks. Households with debt are more likely to be impacted by the scenario than those without debt. However, of those households with debt, the impact of the scenario is greatest on those with relatively little debt.

Their results from the hypothetical scenario suggest that the household sector would have remained fairly resilient to macroeconomic shocks during the 2000s, and that the households that held the bulk of debt tended to be well placed to service it, even during macroeconomic shocks. However, based on this scenario, the effect of macroeconomic shocks appears to have increased over the 2000s. This suggests that household vulnerability to shocks may have risen a little. This might be because some households were in a less sound financial position following the global financial crisis (for instance, because the labour market had weakened and the prices of some assets had declined). As a consequence, shocks of a magnitude that previously would have left these households with a positive financial margin and/or sufficient collateral so as not to generate loan losses for lenders may, following the crisis, have been large enough to push these households into having a negative financial margin and/or insufficient collateral.

The results imply that expected losses (under the scenario outlined) on banks’ household loans were equivalent to a little less than 10 per cent of total bank capital (on a licensed ADI basis), assuming that eligible collateral consists of housing assets only. This result assumes that banks have already provisioned for pre-stress losses, but this may not always be the case, as the deterioration in asset quality may surprise some institutions or may take place before objective evidence of impairment has been obtained. Assuming pre-stress losses are not provisioned for, potential losses as a share of total bank capital roughly double. It is important to reiterate that these estimates are simplistic and could differ to actual losses incurred in reality under this scenario by a large margin. For example, some of these loan losses may be absorbed by lenders mortgage insurance.

Limits To Low Interest Rate Policy

In a recent speech, “Low Inflation in a World of Monetary Stimulus” RBA Deputy Governor Philip Lowe highlighted the impact of low interest rates. Significantly he observes that low interest rates are not translating into buoyant consumer spending. As a result, such monetary policy will not necessarily deliver the desired economic outcomes.

One area where low interest rates do appear to be having the broadly expected effect is on asset prices: global equity markets have been strong; property prices are again recording solid gains in some countries; and bond prices have increased substantially. However, for these increases in asset prices to boost the global economy, households and businesses need to respond by increasing their spending. While in the United States there are now some signs that this is happening, on the whole the response of private spending to higher asset prices has been muted.

Overall, looking at this experience, I find it difficult to escape the conclusion that changes in interest rates are not affecting decisions about spending and saving in the way they might once have done. Undoubtedly, low interest rates are helping to repair balance sheets by lowering debt-servicing costs and by pushing up asset prices. In so doing, they are helping lay the foundations for future growth in consumption and investment. But, while this repair process is taking place, consumption is weaker than it otherwise would be. In turn, subdued consumption growth is feeding through to a more subdued business climate and weaker investment.

Arguably, a similar dynamic has been playing out in government finances in a number of countries. After the financial crisis, many governments found themselves with debt levels that were very high. Like many households, they have responded by tightening their belts. Given the high levels of debt and ongoing imbalances between recurrent revenue and expenditure, few governments have seen the very low interest rates as an opportunity to support long-term infrastructure investment at low cost. Rather, much as households have done, governments have taken advantage of the lower debt-servicing costs to help shore up their finances.

He concludes that low interest rate monetary policies are unlikely to succeed.

Finally, stepping back from the short term, the low interest rates we are seeing globally and in Australia are a direct consequence of an elevated appetite for saving and a muted appetite for real investment in many economies. Monetary policy globally has responded to this reality in a way that a decade or so ago would have hardly seemed imaginable. In doing so it has helped the global economy through a very difficult period. But, at the end of the day, the solution to the problems caused by the disconnect between the desire to save and the desire to invest cannot lie with monetary policy. Instead, it lies in measures to improve the investment environment so that once again there is strong productive demand for the use of our societies’ savings.

Review of Card Payments In Australia

The RBA has issued a paper outlining the proposed scope of a review of card payments in Australia. Given the evolution of payments, the rise of new payment platforms, weaknesses in the current interchange arrangements, payment surcharging and changed economics in the payments value chain, this is timely. Submission on aspect of the Bank’s card payments reforms, should be provided by no later than 24 April 2015.

The RBA outlines a number of factors which indicate a review is needed:

Aspects of the interchange fee system and merchant surcharging practices have raised concerns, some of which were noted in the Board’s 2013 Annual Report and the Bank’s two submissions to the Financial System Inquiry (FSI).
There have been some significant changes to the regulation of card payments in other jurisdictions.
The completion in 2014 of the Bank’s third Consumer Use Survey and second Payment Costs Study have provided a useful evidence base for considering possible changes to policy.
The continuing growth in the role of cards in the payments system since the initial reforms underscores the need for an appropriate regulatory framework for such payments.
Interchange arrangements in the card systems will also affect the nature of new payment arrangements that are adopted by the payments industry. In particular, a more efficient and lower-cost new payment system might be hampered in its development to the extent that it had to match existing interchange payments to card issuing institutions to ensure the participation of banks in the new system.
The FSI has made recommendations directed at the Bank and its regulation of card payments, with particular focus on interchange fee regulation and surcharging.

The Payments System Board would be interested in hearing the views of stakeholders about the issues raised in the previous chapter and possible changes to the regulatory framework that might address those issues.

Some of the possible changes to the regulatory framework are along the lines of those suggested in the Final Report of the Financial System Inquiry (FSI). The Final Report endorsed the broad nature of the Bank’s reforms over the past decade or more. In particular, the Report stated that ‘the Inquiry believes interchange fee caps improve the efficiency of the payments system. Without interchange fee caps, price signals for customers are less clear and outcomes are less efficient because customers can be encouraged to use higher-cost payment methods’ (FSI 2014b, p 171). In addition, the Final Report stated that ‘the Inquiry agrees with the RBA that surcharging can improve the efficiency of the payments system by providing accurate price signals to customers’ (FSI 2014b, p 175).

However, the Final Report noted a few areas where the Inquiry believed the existing regulatory framework could be improved. These included lowering the existing interchange fee caps and broadening their application, and improving the accuracy of price signals in surcharging and the enforceability of mechanisms against excessive surcharging. The FSI Final Report took a holistic view of the card systems, just as the Bank’s earlier reforms have recognised the interlinkages between different aspects of the operations of the card systems. One example is that the Report’s recommendations on surcharging were linked to its recommendations on interchange fees. In particular, the surcharging recommendations reflect the idea that if it was possible to promote the availability of low-cost methods of payment for consumers and merchants, the case for merchants retaining the right to surcharge for those low-cost methods of payment would be reduced.

Specific Issues for Consultation

The Board is interested in the views of stakeholders on the following issues.

With respect to the regulation of interchange fees, the Board is interested in views on the following options:

Publishing thresholds for which payment system providers will be subject to interchange or related regulation, possibly based on transaction values and/or market shares. The FSI Final Report suggests that that this would give new entrants and existing providers greater certainty about how regulation will be applied and would enhance competitive neutrality between providers. Such thresholds could potentially apply to providers such as American Express, as well as other international schemes such as UnionPay, if they entered the domestic market. Thresholds might also be applied for surcharging regulation and could potentially apply to providers such as PayPal.

Broadening interchange fee caps to include other payments between schemes and issuers. There are a range of payments (such as marketing fees, sign-on fees, incentive fees and rebates) from schemes to issuers that are used in both three- and four-party schemes. These other payments can potentially be used to circumvent interchange caps: for example, a four-party scheme can increase fees charged to acquirers and use these funds to pay rebates to issuers, mimicking an interchange payment. Similarly, rebates or incentives paid by a network to an issuer in a companion card arrangement can achieve similar outcomes to an interchange fee. The FSI Final Report suggests that broadening the current interchange fee caps to apply on a broader functional basis would help prevent circumvention of interchange caps and enhance competitive neutrality in the case of companion card arrangements. Regulation of other incentive payments has already been implemented for debit cards in the United States, and is proposed for both debit and credit card schemes in the new EU payments regulation.

Making changes to the interchange benchmark system to reduce the upward ‘drift’ in average interchange rates inherent in the current three-year reset cycle. One option would be to shift to more frequent benchmark observance, such as annually or even quarterly. This would ensure that average interchange rates were much closer to the benchmark, though this might not have much effect on the tendency for the gap between the highest and lowest interchange rates to widen.

Lowering interchange caps. The FSI Final Report suggests that payments system efficiency could be enhanced by lowering interchange fee caps, with the benefits including lower product prices for all consumers as a result of lower merchant service fees, and less cross-subsidisation in the payments system.

Replacing weighted-average interchange caps with hard caps. The FSI Final Report notes that weighted-average caps allow schemes to set interchange schedules which imply relatively high payments costs for smaller merchants without market power and low costs for larger merchants. In addition, the widening in the range of interchange fees raises questions about the transparency of costs for many merchants. Furthermore, the current system of observance of the caps has meant that weighted-average interchange fees in the MasterCard and Visa systems have typically been above the caps. In the new European Union (EU) payments regulation previous settlements reached with MasterCard and Visa, constraining interchange fees for cross-border consumer credit card transactions to 30 basis points per transaction or a maximum weighted-average cap of 30 basis points respectively, will be replaced by a hard cap of 30 basis points on all credit card transactions.

Applying caps as the lesser of a fixed amount and a fixed percentage of transaction values. The FSI Final Report suggests that applying a fixed percentage cap for debit cards, in addition to a fixed-value cap, would ensure low interchange payments on low-value transactions which would promote merchant acceptance. The use of a dual percentage/value cap has also been proposed in the new EU payments regulation, where debit card interchange could be capped at the lower of 20 basis points or a fixed-value cap which member states may set at their own discretion. In the case of credit cards, the FSI Report notes that the introduction of a fixed-value cap would be a significant change and that a transition period might be warranted if it were adopted.

Including prepaid cards within the caps for debit cards. As noted above, there is a degree of ambiguity in how prepaid cards are dealt with under the interchange benchmarks. Accordingly, it would be helpful to clarify this in a review.

Allowing for ‘buying groups’ for smaller merchants to group together (subject to any competition law restrictions) to negotiate to receive the lower interchange rates that are accessible to larger merchants. This option might be considered in the event a future interchange system continued to generate large differences in the interchange rates faced by different types of merchants. A similar measure was part of a settlement between US merchants and MasterCard and Visa in 2012, although that agreement only requires that card companies meet with merchant buying groups, and not that card schemes must offer similar rates to merchant groups that bring similar transaction volumes.

With respect to surcharging, the Board is interested in views on the following options:

A tiered surcharging system, perhaps along the lines of the FSI recommendations. The FSI Final Report suggests that a three-tier approach would be likely to reduce cases of excessive surcharging by providing merchants with clearer surcharging limits that will reduce problems with enforcement in the current system. Alternatively, other variants of a tiered system might be appropriate. The FSI Final Report proposal would include:
– Allowing low-cost system providers to prevent merchants from surcharging, to encourage consumers to use low-cost payment methods. The Final Report suggests that systems would qualify as low-cost if their interchange fees were below the caps for debit systems (or if three-party systems were equivalently low-cost in terms of merchant service fees). Given the widespread holding of debit cards, this would imply that essentially all consumers would be able to make card payments (presumably including in the online environment) without being surcharged.
– Allowing medium-cost providers to limit surcharges to limits set by the Board. The Final Report suggests that schemes would qualify as medium-cost if their interchange fees were below credit card interchange fee caps (and three-party systems could qualify if their merchant service fees were equivalent to those of other medium-cost providers). The limit set by the Board might be based on average card acceptance costs. Such limits would be published, which would ensure that it was immediately observable to card schemes, consumers and others if a merchant was surcharging excessively – this would enhance the enforceability of such limits.
– Allowing high-cost providers to limit surcharges to the reasonable cost of acceptance. Such providers would also be required to disclose that they were high-cost providers so that their customers would understand why they were likely to be surcharged. The reasonable cost of card acceptance would be based on the costs of the particular merchant, meaning that there would remain scope for dispute over whether a merchant was surcharging excessively.

Targeted changes to reduce particular cases of excessive surcharging. The two industries where concerns about surcharging are most vocal are the taxi and airline industries. Surcharging in the taxi industry is becoming the focus of most state taxi regulators. In the case of the airlines, the current fixed-dollar surcharges would appear to be well above the reasonable cost of card acceptance for low-value fares, given that the costs associated with credit cards are typically mostly ad valorem or percentage-based. Accordingly, a simple measure might be to modify the Bank’s surcharging Standard or Guidance Note to allow schemes to cap any surcharges that are not percentage-based at some low fixed-dollar amount. This could result in a significant reduction in surcharges payable on lower-value fares. It is possible that a change such as this, which would be largely independent of potential other changes to the regulatory framework, could be made relatively quickly.

Any other changes to enforcement procedures and disclosure practices. Where merchants wish to surcharge for particular high-cost payment instruments it is important that any charge should be properly disclosed up front and that there is at least one non-surcharged method of payment that is generally available to consumers. The Board is interested in stakeholder views regarding the extent to which these requirements are met by merchants and also in more general views as to mechanisms by which excessive surcharging or incomplete disclosure of surcharges might be addressed.

The Board is also interested in views on some other possible regulatory changes that could improve the way that market forces operate in the cards system:

Strengthened transparency over the cost of payments to merchants and cardholders. To the extent that there continued to be large differences in interchange rates on cards from a particular system, it would seem important for merchants to know the cost of accepting a card at the time of the transaction, so they can make informed decisions regarding acceptance or surcharging. Greater transparency would also be important for consumers to enhance their understanding of whether they are using a low-cost card or a high-cost card that may be surcharged. Measures to improve transparency could include:
– Ensuring that debit and credit cards are more readily identifiable by merchants electronically.
– Requiring, as in the new EU payments regulation, that categories of cards with different interchange fees should be identifiable both visually and electronically, so that consumers and merchants are aware when a high-cost card is being used.
– Requiring, as in the EU payments regulation, that acquirers must offer merchants pricing and billing that separately shows the interchange fee and merchant service charges that apply to each brand and category of cards. While many Australian merchants are now subject to ‘interchange-plus’ pricing for each scheme, others are still subject to blended rates, including between debit and credit, and some merchant statements do not promote a good understanding of card costs borne by merchants.

Further easing of ‘honour-all-cards’ rules to allow merchants to decline to accept cards with high interchange fees. The current restrictions on honour-all-cards rules allow merchants to make separate acceptance decisions on debit versus credit, but could be extended to allow merchants the freedom to decline high-cost cards within a particular scheme.

Facilitation of differential surcharging by merchants. To the extent that the acquiring market was not providing the ability for merchants to surcharge differentially based on the nature of the card, it might be desirable to explore measures that would require card schemes and acquirers to provide merchants with such ability to differentiate. This might be supplemented, as in the EU proposal, with controls on scheme rules or contractual terms that prevent merchants from informing consumers about the cost of interchange fees or merchant service charges: this would mean that Australian merchants could not be prevented from informing customers of their cost of card acceptance if they wished to justify their surcharging policies.

Ensuring that merchants have the ability to choose to route their transactions via lower-cost networks or processors. This might involve requiring, as is the case for debit cards in the United States, that acquirers must route transactions through the network which the merchant has nominated as their preferred option among those networks available on a card. This could provide some offset to the tendency for competition between schemes to drive interchange fees higher. A stronger option, as will be required in the EU payments regulation currently being considered, would be that the scheme activities and processing infrastructure of card networks are legally separated, so as to facilitate competition in the market for processing transactions.

Clarifying arrangements for competing payment options within a single device or application. One option might be along the lines of the proposed EU payments regulation concerning ‘cobadging’ and choice of payment application. Regulatory measures might include restrictions on scheme rules that prevent the inclusion of other payment brands or payment applications on a device (e.g. mobile phone) or that may prevent different payment options being included within a payment application. The proposed EU payments regulation also requires that security standards or technical specifications, and arrangements for routing transactions, should be applied in a non-discriminatory manner when handling two or more different payment brands or applications on a single device. Similarly, providers of payment services might be required to allow merchants or cardholders the option of specifying their own preferences regarding the priority of different networks or payment methods, both on co-badged devices and in mobile wallet applications.

Finally, the Board is also interested in stakeholder views on the appropriate regulatory arrangements for prepaid cards.

General Issues for Consultation

The Board expects that stakeholders may wish to raise other issues concerning card payments and their role in the broader retail payments system. Accordingly, it encourages stakeholders to suggest any additional measures that the Bank should consider in a review of the regulatory framework. The Board will also take account of any relevant responses to the Government’s current consultation on the recommendations in the Final Report of the Financial System Inquiry.

The Board recognises that some of the possible regulatory changes discussed above (e.g. changes to the interchange fee caps) could imply significant changes to business models in the cards industry while other possible changes (e.g. to improve the transparency of costs to merchants) could imply significant systems changes by schemes and acquirers. It will be mindful of these issues as the Review proceeds. However, the Board notes its concerns about the existing cards model which results in most merchants facing significant variability in the cost of card transactions within the four-party schemes, while having no visibility over these costs at the time of the transaction. Similarly, merchants have limited or no ability to respond to these differences by charging differentially or declining to accept high-cost cards. Accordingly, the Board encourages stakeholders to suggest measures that could address its concerns in ways that would minimise adjustment costs for the payments industry.

During the 2007–08 Review, the Board and the Bank spent a considerable amount of time exploring a non-regulatory approach whereby voluntary undertakings from schemes in relation to interchange fees could serve in place of formal regulation. As noted above, ultimately industry participants were unable to arrive at arrangements that the Board considered were in the public interest. International experience also suggests that non-regulatory solutions have been difficult to achieve. Furthermore, the option of removing interchange fee caps was touched on in the Interim Report of the FSI (FSI 2014a, p 2-31) but not endorsed by the Final Report (FSI 2014b). The Board sees challenges in a nonregulatory approach, but would nonetheless be interested in stakeholder views on approaches that could result in a sustainable framework that met the Board’s concerns and were in the interests of competition and efficiency in the Australian payments system.

Finally, while it is important that any changes to the regulatory system should occur in a way that recognises all the interdependencies, the Board is interested in views about whether there are particular targeted changes, for example to the surcharging framework, that could usefully occur ahead of any more general package of reforms.

RBA – No Rate Change Today

At its meeting today, the Board decided to leave the cash rate unchanged at 2.25 per cent.

Growth in the global economy continued at a moderate pace in 2014. A similar performance is expected by most observers in 2015, with the US economy continuing to strengthen, even as China’s growth slows a little from last year’s outcome.

Commodity prices have declined over the past year, in some cases sharply. The price of oil in particular has fallen significantly. These trends appear to reflect a combination of lower growth in demand and, more importantly, significant increases in supply. The much lower levels of energy prices will act to strengthen global output and temporarily to lower CPI inflation rates.

Financial conditions are very accommodative globally, with long-term borrowing rates for several major sovereigns at all-time lows over recent months. Some risk spreads have widened a little but overall financing costs for creditworthy borrowers remain remarkably low.

In Australia the available information suggests that growth is continuing at a below-trend pace, with domestic demand growth overall quite weak. As a result, the unemployment rate has gradually moved higher over the past year. The economy is likely to be operating with a degree of spare capacity for some time yet. With growth in labour costs subdued, it appears likely that inflation will remain consistent with the target over the next one to two years, even with a lower exchange rate.

Credit is recording moderate growth overall, with stronger growth in lending to investors in housing assets. Dwelling prices continue to rise strongly in Sydney, though trends have been more varied in a number of other cities over recent months. The Bank is working with other regulators to assess and contain risks that may arise from the housing market. In other asset markets, prices for equities and commercial property have risen, in part as a result of declining long-term interest rates.

The Australian dollar has declined noticeably against a rising US dollar, though less so against a basket of currencies. It remains above most estimates of its fundamental value, particularly given the significant declines in key commodity prices. A lower exchange rate is likely to be needed to achieve balanced growth in the economy.

At today’s meeting the Board judged that, having eased monetary policy at the previous meeting, it was appropriate to hold interest rates steady for the time being. Further easing of policy may be appropriate over the period ahead, in order to foster sustainable growth in demand and inflation consistent with the target. The Board will further assess the case for such action at forthcoming meetings.

Home Lending Up To $1.43 Trillion

Latest data from the RBA shows that home lending is worth $1.43 trillion, to end January. In the month, lending rose $8.5 billion, or 0.6%. However, investment home lending grew at 0.8%, whilst owner occupied lending grew at 0.49%. Investment lending was at a record 34.3% of total housing.

More broadly, total lending was up 0.6% from last month, and 6.2% year on year. The share of lending to business continued to fall as a share of total lending, now down to one third of all funds borrowed. This needs to be lifted if sustainable growth is to be delivered. Banks are biased toward ever more home lending, thanks to lower losses and advantaged capital requirements.