Frankfurt Voice. Euro payment transactions: EU regulation on charges threatens to distort competition. International International topics Economics

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1 International International topics Economics Editor: Bernhard Speyer Tel.: Publication Assistant: Melanie Haibach Tel.: Internet: Deutsche Bank Research Frankfurt am Main Germany Fax: Managing Directors Axel Siedenberg Norbert Walter Euro payment transactions: EU regulation on charges threatens to distort competition The European Commission has plans for legislation that would drastically reduce charges for cross-border payment operations within the EU. According to its proposal for a regulation, charges for cross-border payment transactions up to EUR 50,000 are generally to be the same as those for corresponding domestic payments from January 1, The rule would apply to cross-border credit transfers and cheques from January 1, Administrative price-fixing is not necessary, though, as institutions offering payment services have already taken far-reaching steps to make cross-border payment operations more efficient in future, and thus to lower their charges for these services. Some banks have already substantially reduced their charges for electronic payment orders. With EU-wide bank identifier codes (BICs), international bank account numbers (IBANs) and standards for forms (IPI, MT103+), banks will very soon be able to introduce straight-through electronic processing in cross-border payments. If cross-border retail payment systems and centralised clearing and settlement structures are established this could bring further cost reductions. The proposed EU regulation would disturb the development of the market by hindering market-driven pricing. Even within a single euro-zone payment area it must be possible for customer charges to reflect the relevant settlement costs. These remain steep for crossborder operations, which is the reason why charges to customers are also still relatively high. In addition, reporting obligations via-à-vis national authorities make cross-border payments more expensive, as well as slowing them down. As soon as possible, these obligations must be reduced and restricted to payments of more than EUR 50,000. The regulation would force banks to execute cross-border payments at less than cost price and to compensate the resultant losses through cross-subsidisation. This could prompt smaller institutions to withdraw from the market, which would reduce competition. Administrative fixing of bank charges would be unlikely to withstand a judicial review by the European Court of Justice. Steffen Kern, (steffen.kern@db.com)

2 The European Commission has proposed a regulation in order to bring about a drastic reduction in charges for cross-border payments of up to EUR 50,000 within the European Union (EU). Such small-value transactions are in future not to be more expensive than similarly sized domestic payments. Low, but cost-covering, prices are in the interest of consumers and providers alike. Surveys on cross-border payment operations in the EU indicate that the settlement of cross-border retail payments can be improved considerably in the future. It is doubtful, though, whether the measures currently proposed by the Commission can help in attaining this goal. If payment service providers were forced by law to bring charges for cross-border payment transactions into line with prices for domestic operations, this would probably lead primarily to a distortion of competition among financial services institutions in the EU, eliminate incentives to enhance efficiency through investment, and thus ultimately run counter to the interests of consumers. High charges for cross-border payments... It is a fact that charges for cross-border small-value payments in the EU are high compared with charges for national payments. A survey 1 carried out for the European Commission shows that total charges for a cross-border credit transfer 2 within the euro area currently average EUR The lion s share EUR on average has to be paid by the originator; the beneficiary pays EUR If a bank customer withdraws EUR 100 at a cash dispenser in another euro-zone country, this costs him roughly 4.2% of that amount. Charges for retail purchases made using a bank card are relatively low at EUR 0.16 per payment. 3 Charges for cross-border payments differ greatly from country to country. They probably also vary widely from institution to institution. Charges for comparable national transactions are generally considerably lower. Banks frequently even offer such services free of charge.... not without reason There are, however, specific microeconomic reasons for the wide gap between charges for national and cross-border payment operations. Low demand: There is, first of all, very little demand for foreign payment operations. Whereas some 100 million domestic payments are settled daily in the euro area, cross-border payments probably number only a few hundred thousand. 4 The institutions therefore cannot achieve anywhere near the same economies of scale in cross-border payments. Expensive infrastructure: Secondly, the establishment and maintenance of the infrastructure required for cross-border payments, and the settlement of transactions, are relatively cost-intensive. The majority of cross-border small-value payments are channelled through bilateral account relationships, i.e. through the system of correspondent Commission proposes legislated reduction in charges for cross-border payments Value chain of cross-border retail payments*) Customer Originator s bank Originator s bank Cross-border clearing Beneficiary s bank Beneficiary s bank Customer *) Source: Deutsche Bank AG Paper-based Electronic Receipt Distribution Balance check Capturing of data Validation Archiving Regulatory reporting Booking IT processing Message handling Nostro reconciliation Settlement via EBA, TARGET, correspondent bank Message fees Data comparison Limit check Correction Customer advice Booking IT processing Message handling Regulatory reporting Statement or other notification 1) Institut Européen Interrégional de la Consommation, Bank Charges in Europe, Report for the European Commission, May 2001, pa.eu.int/comm/dgs/ health_consumer/library/surveys/sur24_en.pdf. 2) Average for the EMU countries, with the exception of Greece, for a transfer of EUR ) For a purchase for an amount of approximately EUR 25. 4) Only about 0.1% of the total number of payments settled by Deutsche Bank AG are small-value payments across borders in Europe. Economics 3

3 banks. Owing to the complexity of the system, it is very expensive for the individual institution to maintain a network that provides full geographical coverage. In the past, projects to establish centralised structures in cross-border payments failed to get off the ground as they were not economic. The viability of investing in infrastructure for payment transactions has to be studied closely in advance, particularly because of the very low demand in cross-border business. Lack of EU-wide standards: An even weightier reason is the costs that banks incur for data capture and for settlement. These costs are due to the fact that each EU member state has different technical standards. Formats for bank sort codes and account details still differ, making it necessary to process payment orders individually on the whole, and thus manually. Many orders also require additional work because the details given are either incomplete or contain errors. Straight-through processing (STP), i.e. almost complete automation, has not been possible so far because of the lack of standardisation, whereas it has been customary in national payment systems for years. Extensive reporting obligations: Even in the EU single market, crossborder payments still have to be reported to the national central banks; the obligations are extensive and often differ from country to country. This makes payment operations more inconvenient for customers, more expensive for the banks, and lengthens the period required for processing. These four factors make it clear that the value chain of cross-border payments is considerably longer and involves much higher costs than the chain for national payments. This is consequently reflected in current charges for cross-border payments. The Commission proposal... The purpose of the proposal for a regulation on cross-border payments in euros 5, presented recently by the European Commission, is to improve the functioning of the internal market and to encourage the transition to a single domestic European payment area in the European Economic and Monetary Union. The Commission aims to ensure that charges for cross-border payments in Euro are no higher than those for payments in Euro involving no crossing of borders. The proposal therefore contains a series of measures 6 (see box) that concentrate on regulating charges for cross-border electronic payment transactions. As a general rule, charges for cross-border payments up to EUR 50,000 are to be the same as the level of charges levied in respect of corresponding national payments from the beginning of For two types of cross-border payment there is to be a transitional period: the rule is to apply to cross-border credit transfers and cheques from January 1, 2003 at the latest. Proposal for an EU regulation on cross-border payments in euro*) With effect from 1 January 2002, charges levied by an institution in respect of crossborder electronic payment transactions in Euro up to EUR 50,000 shall be the same as the level of charges levied by the same institution in respect of corresponding payments transacted within the Member State in which the establishment of that institution executing the cross-border electronic payment transaction is located. With effect from 1 January 2003 at the latest, charges levied by an institution in respect of cross-border credit transfers and cross border cheques in Euro up to EUR 50,000 shall be the same as the level of charges levied by the same institution in respect of corresponding credit transfers and cheques transacted within the Member State in which the establishment of that institution executing the crossborder transfer or cross border cheque is located. Far-reaching requirements for banks to inform customers of the charges on crossborder transactions and currency exchange transactions. Requirements for banks and customers to communicate BIC and IBAN codes. Member States shall remove with effect from 1 January 2002 at the latest any national reporting obligations for crossborder payments up to EUR 12,500 for balance of payment statistics. With effect from 1 January 2004, the amount will be increased up to EUR 50,000. Member States shall remove with effect from 1 January 2002 at the latest any national obligations as to the minimum information concerning the data of the beneficiary which prevent automation of payment execution. *) C OM(2001) 439, "P roposal for a regulation of the European P arliament and of the Council on crossborder payments in euro", C ommission of the European C ommunities 5) COM(2001) 439, Proposal for a regulation of the European Parliament and of the Council on cross-border payments in euro, Commission of the European Communities. 6) The proposal applies to cross-border transactions with credit cards, debit cards, charge cards, electronic money instruments, cash dispensing machines, credit transfers and cheques. 4 Economics

4 ... not in keeping with the spirit of the single market For customers, such a rule would be highly attractive in the short term. But there is reason to doubt that it would be beneficial in the long run, as it is hardly compatible with the goals of the EU single market on regulatory, microeconomic and legal grounds. Regulatory: The fixing of charges by law would contravene the principles of the market economy, according to which prices are determined by supply and demand. The proposal is based on the assumption that within a single European payment area charges for national and cross-border payments must be the same. But this appears questionable. A single market is generally understood to be an economic area in which there are no internal administrative barriers to trade. The same applies to a single payment area. While administrative trade barriers do not represent a cost factor in such an economic area, there are other costs that are not eliminated and have a major influence on charges for services. As long as service providers settlement costs for cross-border payments are higher than those for national payments, it should and must be possible for this to be reflected in the charges for the services rendered as in the EU single market for transport or telecommunications services. A single payment area clearly does not imply uniform charges, but merely a uniform framework for the free development of supply and demand and thus the charges for payment services. The proposed regulation would not lead to genuine EU-wide harmonisation of charges for cross-border payment operations either. Since charges for domestic payments differ between the EU member states, there would also be wide deviations between charges for crossborder payments even after the regulation came into force. This would tend to favour banks in countries where charges for national payments are high. Microeconomic: If charges cannot be determined by market forces which would be the case under the Commission s current plans this creates microeconomic distortions. As a look at the value chain shows (see table p. 3), the marginal costs for cross-border payments are considerably higher than those for national transactions. If equal charges were legally prescribed, banks would be compelled to provide crossborder payment services at less than cost price, i.e. at a loss, and this loss would have to be compensated through higher profits in other areas. Such cross-subsidisation would be uneconomic. Since turnover in crossborder payments is low in any case, the proposed regulation could cause institutions especially smaller banks to withdraw from this field of business entirely. This would lead to greater market concentration, weaken competition, and ultimately hurt consumers. The proposed regulation would also create negative incentives for the institutions in their pricing policy. The rule that charges must be uniform, for example, would spur institutions to raise prices for national payments. If this were not possible, institutions would no longer have the same motivation to let customers share in the benefits of improved efficiency in national payment operations by lowering their charges. Charges to originator, cross-border transfers*) Amount per transfer in EUR FR DE NL IT ES *) Prices for outgoing transfers in EUR, scaled according to transfer amount in EUR 000. Source: Deutsche Bank AG Charges to beneficiary, cross-border transfers*) Amount per transfer in EUR FR DE NL IT ES *) Prices for incoming transfers in EUR, scaled according to transfer amount in EUR 000. Source: Deutsche Bank AG Charges to originator, domestic transfers*) Amount per transfer in EUR FR DE NL IT ES *) Prices for transfers in EUR, scaled according to transfer amount in EUR 000. Source: Deutsche Bank AG Proposed regulation could reduce competition Danger of greater market concentration Economics 5

5 Just how strongly these negative incentives would work to the customers disadvantage would depend on the intensity of competition among the institutions providing cross-border payment services. Legal: Administrative fixing of bank charges would be unlikely to withstand a judicial review by the European Court of Justice as it would conflict with the principles enshrined in the EU Treaty, especially the principle of an open market economy with freedom of competition. Nor are there any discernible grounds relating to EU monetary law or the creation of the internal market that would justify such intervention. All in all, the proposal to legally prescribe the approximation of prices for cross-border and national payments is therefore a problematic approach. It is to be feared that the resultant distortions of competition would ultimately be to the disadvantage of the consumers in the EU. This view is shared by the Bundesbank. 7 In past statements, the European Central Bank has also seen no need for the state to influence the markets. Market forces hold promise of a more efficient solution Despite these reservations, a reduction in charges for cross-border payments is desirable. And this can be achieved without administrative price-fixing. While the necessary improvements in efficiency will require additional efforts by the institutions providing payment services, i.e. the banks, the authorities can also contribute by improving the regulatory environment for payment operations. Automation: Charges for cross-border payments depend largely on the degree of automation. The aim is to achieve straight-through processing (STP), which is already practised in most EU countries in national payments. Standardisation: For STP it is essential that the exchange of information in payment operations be very highly standardised. This applies to the format of account numbers and bank sort codes as well as the other information provided on forms. Infrastructure: Further cost reductions could come if cross-border retail payment systems and centralised clearing and settlement structures are established. Reporting obligations: National reporting requirements continue to slow cross-border payments in the EU and make them more expensive. The proposal rightly requires these reporting obligations (see box p. 4) to be restricted. 8 It would be preferable and justifiable, though, to set the limit at EUR 50,000 right from the beginning of Transparency: Banks and consumers must observe the standards necessary for STP in cross-border payments in order to minimise settlement costs in future. There must be incentives for users to pass on all the necessary information. Negative incentives for credit institutions in pricing policy Administrative price-fixing would not withstand judicial review by ECJ Bundesbank says price regulation creates additional problems and does not deal with causes Lower charges for cross-border payments are welcome, and attainable through straight-through processing, standardisation of data formats and forms, establishment of central clearing and settlement structures, and reduction in reporting obligations Banks and customers must observe new standards 7) According to Hans Georg Fabritius, member of the Directorate of the Deutsche Bundesbank, price regulation creates additional problems and is not a good way to tackle problems of market efficiency as it only treats the symptoms, but does not deal with the causes. See Eine Preisregulierung im Zahlungsverkehr macht keinen Sinn, Frankfurter Allgemeine Zeitung, July 16, 2001, p ) Germany has had a limit of EUR 12,500 since January 1, Economics

6 Discernible progress The banks in the EU have, for their part, already taken considerable action on these points. Knowing the stance of the EU 9, they have invested heavily since 1997 to increase efficiency in cross-border payments. Cost pressure in this area has been dampened, as the recent report for the Commission also shows. Although charges for cross-border credit transfers in EMU have risen slightly between 1999 and 2001 (+1.6%), the increase was far below the general rate of price increase in the services sector (+4.3%) and in the financial sector (+8.4%) in the euro area. Charges for payments abroad by bank card actually dropped 17%. The fall in charges was particularly pronounced in Germany, where credit transfers to other EMU countries became 13.4% cheaper and charges for payments by card plunged 71%; the execution period for crossborder credit transfers was also reduced by 21%. Examples based on individual banks show that, with high investment, it is possible to make enormous progress in cross-border payments. Deutsche Bank s retail banking arm, for instance, has succeeded in slashing prices for electronic credit transfers to other European countries 10 to EUR 1.50 per transaction, a reduction by up to 80%. Since July 1, 2001 customers of Deutsche Bank AG have been able to withdraw money free of charge from the cash dispensers of banks in the USA, the UK, Canada and Australia with which a corresponding agreement has been concluded. But the introduction of settlement procedures based on STP is likely to bring even greater efficiency gains than those achieved by European payment service providers so far and thus even greater potential for reducing charges. The main prerequisites have already been created: Technical standardisation: Definitions have been agreed for the international sort code BIC (Bank Identifier Code), international bank account number IBAN, and standard forms IPI (International Payment Instruction) and MT103+ (updated version of the SWIFT format). STP credit transfers will probably be widely possible from With STP the foundations have been laid for the development of cross-border retail payment systems. STEP 1 the pan-european, small-value payment system of the European Banking Association which has been in operation since November 2000 shows that the market is making use of the new possibilities. The introduction of another private international payment system, WATCH (Worldwide Automated Transaction Clearing House), is planned for summer The European providers of cross-border payment services are clearly taking great pains to make transactions in this increasingly important area of the single market cheaper, simpler and faster. This market-driven process would be severely disrupted by administrative price-fixing as proposed by the European Commission. Institutions invest heavily, dampen cost pressure, and benefit customers through cuts in charges Deep price reductions at large, innovative payment service providers Payment service providers poised for further efficiency gains through internationally valid bank identifier codes, bank account numbers, and forms, straight-through processing, and development of cross-border payment systems EU regulation on charges would disrupt market-driven modernisation 9) Directive 97/5/EC of the European Parliament and of the Council of 27 January 1997 on cross-border credit transfers, and Communication from the Commission to the Council and the European Parliament COM(2000) 36, Retail payments in the internal market. 10) Member countries of the EU and EFTA; charged from May 15, Economics 7

7 Cross-border payment charges and the euro: no direct link With just a few months to go until the introduction of the euro is completed, consumers are asking about the advantages that can be expected from the single currency. Despite all the benefits of economic and monetary union, a reduction in charges for cross-border payments to the level for national payments will not come as a direct consequence of the euro, nor should it be expected as an indirect result. Even after the euro banknotes and coins have been introduced, the nationally oriented structures for handling cross-border payments will remain in place for the time being, giving rise to high transaction costs and thus relatively high customer charges. A statutory reduction of these charges as foreseen in the Commission s proposal for a regulation obviously looks politically attractive as a means of achieving a higher degree of identification of the EMU citizens with the euro in the short term. But it is not a way of bringing down charges for cross-border payments that is compatible with economic principles. This can best be achieved by continuing and intensifying the structural adjustments that are already in progress. Steffen Kern, (steffen.kern@db.com) Administrative reductions in charges would be wrong way to make euro more popular, owing to danger of unrealistic expectations Ongoing structural adjustments must be continued and intensified All Deutsche Bank Research products are also available by . Subscribers receive the electronic publication on average four days earlier than the printed version. If you are interested in receiving this product by , please get in touch with your Deutsche Bank sales contact or with the DB Research Marketing Team: marketing.dbr@db.com Publisher: Deutsche Bank AG, DB Research, D Frankfurt am Main, Federal Republic of Germany, editor and publisher, all rights reserved. When quoting please cite Deutsche Bank Research. The information contained in this publication is derived from carefully selected public sources we believe are reasonable. We do not guarantee its accuracy or completeness, and nothing in this report shall be construed to be a representation of such a guarantee. Any opinions expressed reflect the current judgement of the author, and do not necessarily reflect the opinion of Deutsche Bank AG or any of its subsidiaries and affiliates. The opinions presented are subject to change without notice. Neither Deutsche Bank AG nor its subsidiaries/affiliates accept any responsibility for liabilities arising from use of this document or its contents. Deutsche Banc Alex Brown Inc. has accepted responsibility for the distribution of this report in the United States under applicable requirements. Deutsche Bank AG London being regulated by the Securities and Futures Authority for the content of its investment banking business in the United Kingdom, and being a member of the London Stock Exchange, has, as designated, accepted responsibility for the distribution of this report in the United Kingdom under applicable requirements. Deutsche Bank AG, Sydney branch, has accepted responsibility for the distribution of this report in Australia under applicable requirements. Printed by: HST Offsetdruck GmbH, Dieburg. Print: ISSN / Internet: ISSN Economics