Finance Committee on June 9th, 2009

[Prof. Ian Lee]

I'll respond to it very quickly.

There are loyalty programs throughout the economy. At Carleton University we have coffee shops and they give out a card, which they punch every time you buy a coffee, and the tenth coffee is free. It's the same concept as getting a discount on your credit card. It's called discount for volume. If you patronize that business more than another business, I'm giving you an incentive to come back to my business over and over, and that's the value creation; that's the growth to my business as a business manager.

[The Co-Chair, Conservative, Michael Chong]

Thank you, Mr. Lee.

Mr. Rota, you now have the floor.

[Anthony Rota, Liberal, Nipissing—Timiskaming, ON]

Thank you, Mr. Chair.

There were a couple of comments made, one in particular, that I found a bit disturbing. It had to do with the system as we have it still working and there not being a problem yet.

As parliamentarians we have to look at the good of all society, and I just want you to realize that the fact it's working now doesn't mean that down the road it may not be working. If we see something coming up, I think we want to look at it to prevent any possible problems, for the betterment of everyone.

The system as it stands right now is that you have the providers, who are the card issuers, and you have the banks and the consumers, who are basically the customers of the providers. Under a competitive system where you have two major cards, the providers are vying for the business of the banks and vying for the business of the consumers so that they will take their cards.

The one thing I find very disturbing is that when they're vying for that business, they offer more benefits. They offer to differentiate themselves. And how do they do that? I think Mr. Mulcair asked the question, “Who pays for it?” It's at the expense of the merchant.

I know the argument will be that the merchant is selling his or her receivables and that this is the cost they pay. Usually, when you have a cost, you can negotiate something and it's fixed.

You mentioned Adam Smith earlier. I believe that in the economy Adam Smith dealt with, things were much simpler. You had to have the same product. It's been a few years since I've studied Adam Smith, but basically the economy, in his view, has to be pretty well level: you have similar products and a relatively barrier-free entry into the market.

In a system like the one we have with the banks, in which you have two major players, the merchants are basically the pawns in all this, and the costs are passed on to the merchants, who have to have this service. Do you not find there is something wrong with this system?

[Prof. Jack Carr]

I'll respond to that. There are a number of points you made, and let us hope I get all of them.

Let me get to the Adam Smith point that I made about people lobbying government. That occurs all over the world; it has occurred since 1776 and it occurs today. People act in their own best interests—that was Adam Smith's point—and if you have government setting rules and regulations, they'll try to get the rules set in their own interest. That hasn't changed. The nature of the economy is much more complicated, but that fundamental fact is still the same.

On these systems, I think it's important to stress, when one has to understand how it is and who bears the cost, what happened 40 to 50 years ago. Only cash and cheques were used. Then credit cards came along. Credit cards could only survive if they innovated, if they were more efficient. An example I gave is, if I go to Tim Hortons and swipe my credit card, it's fast; or if I go to service stations, it's faster—it's more efficient. They need fewer employees to take cash, if I do it myself. I can make online transactions.

When you have innovation and it's efficient, the new system can offer the product with more benefits at a lower cost. You ask who pays for the benefits. No one does. They result from building the better mouse trap. If you build a better mouse trap, you can sell it cheaper and give a better product. This selling the cheaper.... As Professor Lee said, when you give the loyalty programs or you give all these benefits, the customer is getting it cheaper, because it's a superior product—not in all transactions, but in a lot of transactions.

That's how credit cards could survive. They provide a better product at a lower price. The merchants only see these benefits being given to the customers; they don't see that these transactions are being done more efficiently and that these customers are now being brought in. That's the gain.

[The Co-Chair, Conservative, Michael Chong]

Mr. Lee, did you want to add—

[Anthony Rota, Liberal, Nipissing—Timiskaming, ON]

Can I go to Mr. Lee? I have a question for Mr. Lee, and it will probably lead right into this, if you don't mind.

[Prof. Ian Lee]

Can I respond to that?

[The Chair]

Go ahead, very briefly, so that Mr. Rota can move on.

[Prof. Ian Lee]

You said one thing that caught my attention. You said the merchants are pawns, implying that they have no choice. I will test your theory. Is any merchant forced to take credit or debit? No, they can take cash or cheque, but they choose not to because they know deep down that cash and cheque are far more expensive than debit or credit. That's why they're taking it.

[Anthony Rota, Liberal, Nipissing—Timiskaming, ON]

This leads me to my question. You mentioned again that cash and cheque are more expensive, or that debit and credit was cheaper. What I have here is a study, a discussion paper by the Bank of Canada, that looks at a transaction that is about $36.50, which is about average, and shows that the average cash transaction cost is 25¢, debit comes in at 19¢, and credit at 82¢. It's more than three times the next level.

What you're arguing, basically, is that credit is much cheaper. What I fear with the debit, if it goes to a percentage basis, is that all of a sudden you're just changing money from one place to another, yet you're charging a percentage, and it can become quite substantial. In fact, it's more than three times as much.

The argument is that with the better card, the incentive card, people will spend more money. There is an argument for that. I don't agree with your assertion that the use of card payments can stimulate impulse, especially on larger purchases.

However, this doesn't apply to certain categories, such as grocers or gas retailers, who must contend with very small margins as it is. What we've effectively done is take a fixed level of consumption, and I don't think it's really fair to those consumers that they should have to pay a higher rate on an interchange rate that offers all these benefits. They have very thin margins. They don't have a choice whether to choose to accept the base model or the Cadillac model, for lack of a better word.

[The Co-Chair, Conservative, Michael Chong]

Thank you very much, Mr. Rota.

Be brief, Mr. Lee, before we move on to Mr. Dechert.

[Prof. Ian Lee]

I have two quick responses.

I have looked at several studies, including the Bank of Canada study, and I have looked at it with a couple of chartered accountants from the school. I believe that every study that's been done on the cost of payments has radically under-estimated the cost of cash, because they have not factored in the cash custody required—safes, two people counting the cash, and so on. I think the cost of cash, although I can't give you a number, is probably double or triple or quintuple, because there has not been a full cost-benefit analysis using the kinds of techniques that the PBO has used, using full cost accounting. That's my response.

[The Co-Chair, Conservative, Michael Chong]

Thank you, Mr. Lee.

Thank you, Mr. Rota.

Mr. Dechert.

[Bob Dechert, Conservative, Mississauga—Erindale, ON]

Thank you, Mr. Chair.

On a point of information, I think if Mr. Mulcair were to actually read the Income Tax Act, he would find that the use of a credit card reward point of any kind on rewards earned on a corporate transaction is a declarable taxable benefit. That's been in the Income Tax Act for many years, I believe.

Gentlemen, thank you very much for your presentations. Has any of you studied the interest rates charged by credit card companies and the relationship between the rather high rates of 19% to 20% often charged on these credit cards and the prime interest rate? In your view, what is the average effective interest rate earned by the banks and the credit card companies on these rates?

[Prof. Ian Lee]

I have looked at it. In fact, DBRS has a beautiful study that came out only three months ago. Remember that 70% of all cardholders pay off their credit card in full within the 30-day interest-free period, so they're not getting the 19%. Their effective gross yield is 13%; then you deduct costs of funds and you deduct the charge-off rate. Of course it varies over time in terms of the cost of funds and the cost of charge-offs; right now the cost of funds is low and the cost of charge-offs is skyrocketing, but the net is somewhere around 5% when you take off the cost of funds, the cost of charge-offs, and the cost of running the business.

This is what people are missing. They look at that big number of 19% and say “Oh, my goodness”, but they're not getting 19%. They're only getting 13%, and they have to pay for the charge-offs, they have to pay for the cost of funds, and they have to run the business. That brings it down to somewhere in the 5% range, and I don't think anyone would argue that a 5% return is outrageous.

[Bob Dechert, Conservative, Mississauga—Erindale, ON]

I see.

[The Co-Chair, Conservative, Michael Chong]

Thank you, Mr. Lee.

Mr. Carr, did you have something to add to that?

[Prof. Jack Carr]

I haven't got any studies, but I am a monetary economist. Recently what's happened is that the prime has fallen because of the fall in economic activity, but the risk in the credit card business has also gone up. You would not expect to have a one-to-one correlation between the fall in prime and the fall in the interest rate charged on credit cards. It's more expensive now, given the high risk among those cards. That has to be taken into account.

When you have no change in the risk, you would expect closer correlation, but when they move in opposite directions, you wouldn't expect them to move together.

[Bob Dechert, Conservative, Mississauga—Erindale, ON]

Thank you.

Gentlemen, a number of the retail organizations have told us that the contracts they enter into with credit card companies often restrict them from advertising the cash discount price. Some of the credit card companies deny that's the case, but there seems to be some discrepancy there.

Have you studied what the impact would be of retailers advertising a cash discount price in all transactions? What percentage of consumers do you think would be likely to take them up on that cash discount offer if it were offered?

[Prof. Jack Carr]

I haven't studied it and I don't know this dispute. All I know is that credit card companies tell me that you can do it. We know it can be done in Australia. There's no change. We know here it can be done--

[Bob Dechert, Conservative, Mississauga—Erindale, ON]

The question is, can you advertise?

[Prof. Jack Carr]

In Canada I have received discounts for cash, and I've seen it advertised, so there doesn't appear to be a problem. However, it's still rare, and you have to ask yourself why it is rare. In Europe it's rare. The argument has to be that it's rare because cash is costly, and therefore you don't want to put people.... In some places it's used, and for certain transactions as well.

Mr. Mulcair worries about avoidance of income tax. Cash is one of the clear ways of avoiding income tax. If you want to pay for something and avoid income tax, you pay in cash. That becomes a problem, and retailers may want to steer you to cash exactly for that reason.

[Bob Dechert, Conservative, Mississauga—Erindale, ON]

Presumably if consumers knew that they had a cash option, maybe more would take advantage of it.

I want to ask Professor Scholnick a question. I was rather interested in your analogy of a shopping mall as a platform provider. I know that mall owners often charge a base rent plus a percentage of sales done by the merchants in those malls. How do those fees compare with the actual cost of providing the mall facilities, for example?

[Prof. Barry Scholnick]

I'm not an expert on shopping malls, but the economic argument for the notion of a shopping mall as a platform is the agenda of the mall operators. Their game is to bring in lots of merchants and lots of shoppers and provide this platform. The second part of their business model is to then extract money. These are businesses. They want to make as much money as possible. That's their job.

The interesting part is who they extract the money from. What you don't see is that when shoppers walk into the mall, shoppers have to pay to get into the mall. What you have is the shopper coming in free, but the merchants and the shops in the mall are paying for essentially all the facilities that the mall provides.

[The Co-Chair, Conservative, Michael Chong]

Thank you, Mr. Scholnick. Thank you, Mr. Dechert.

We'll briefly hear from Mr. Carr.