Fed Data Shows Economics of Interchange: 86% of Fees Fund Rewards Programs

PYMNTS Intelligence noted in recent research that at the same time that consumers are using their credit cards to navigate an inflationary environment, and to purchase everyday essentials such as groceries, they also value the rewards tied to that spending.

Consumers use general purpose cards across all age and income levels. The data shows that more than 80% of consumers receive rewards offers from their credit cards, and 72% used these rewards in the 90 days leading into PYMNTS Intelligence’s surveys.  More than a third of the more than 3,200 consumers we surveyed received cash-back rewards on their purchases.

Turning Interchange Into Rewards

Research this week from the New York Fed underscores the economics of interchange fees, putting a number on the scale and scope of the rewards programs and how they are paid for, and that at a high level keep the four-party card ecosystem running. The ecosystem’s been around for decades, the funding mechanism’s not new, but the figures show just how the rewards expenses — for the six largest card issuers at about $67.9 billion — are covered.

The Fed’s data delves into the extend to which the rewards expenses are covered by the banks’ interchange income. The Fed found that banks’ average interchange income is 1.82% of purchase volume on average, while rewards costs are 1.57%.

The majority of the income, then — at about 86% — is passed on to cardholders in the form of rewards. Banks and payment networks are in the ever-constant midst of upgrading and improving their fraud defense systems, and the more cardholders use their cards, the more the rewards programs and the defenses must be expanded.

The economics of interchange, whether credit or debit, remains a timely topic. The U.K.’s in the midst of a battle over debit interchange that would cap those fees. In the U.S., the Credit Card Competition Act, reintroduced in the last Congress, may surface yet again, would seek to drive interchange fees lower as merchants choose the networks over which they would route card transactions.

The Four-Party Model

But as it stands now, in the four-party model that’s been in place for decades (the consumer, the merchant acquirer, the card issuing bank and the merchant) the interchange fees are paid by merchant acquirers to the card issuer.

Interchange fees are a percentage of a product’s purchase price (around 2% usually, per the Fed’s analysis) that is charged to the seller and paid out to the banks. As Karen Webster noted in this column, the network “isn’t touching the interchange fee, which goes right to the issuer. And … the interchange fee isn’t a cost to the consumer. The issuers get the fees and generally pass them along to consumers in the form of rewards and other benefits.”

As for proposed caps, and the contention that merchants would pass savings onto consumers, and the consumers ultimately benefit, economist David Evans has estimated in the “The Impact of the U.S. Debit Card Interchange Fee Caps on Consumer Welfare: An Event Study Analysis,” banking customers “lost more on the bank side than they gained on the merchant side,” by as much as $25 billion in discounted value dollars, as a result of the interchange fee cap initially set in place by the Durbin Amendment.