October 1, 2004

Volume 22, Number 10

Panel of Economists

Databank

Interest Rate Outlook

Credit Card Acceptance: What to Negotiate

Over the past decade, an increasing number of governments have established credit cards as an accepted form of payment for government services. When establishing or renewing contracts with credit card firms, it is important to negotiate effectively to protect the government's financial interest. This article reviews some of the key topics a government should understand and negotiate. For additional information on credit card acceptance, readers should consult GFOA's new publication, Banking Services: A Guide for Governments.

Vendor Selection. Governments interested in accepting credit cards have a variety of options regarding vendors. Qualified vendors can be found in a number of places. The financial institution where the government has its primary banking relationship is an obvious candidate to include in a vendor list. In addition, MasterCard and Visa both maintain current lists of financial institutions that offer acceptance services to governments. Discover and American Express sometimes can offer referrals as well. There are also highly qualified companies that are not general purpose banks that specialize in credit card acceptance.

Like any service involving cash management, when considering an external vendor the prudent course of action is to check references carefully. In particular, it is beneficial that the vendor has experience in card acceptance with other government agencies.

Size of Portfolio. One of the most important factors in determining the cost of credit card acceptance is the number of transactions and dollars processed over the course of a year. Like so many services, rates are variable and volume discounts are available. Therefore, by grouping different departments from a single unit of government, lower rates can be obtained. Even better, combining units of governments in a consolidated request for proposal can provide greater purchasing power. For instance, a park district, a municipality, and a county that all serve the same geographic area can have a single contract with an acquiring bank and get the benefit of their combined transaction volume. At the same time, they can keep their financial transactions and reporting separate.

When contacting potential vendors, two immediate questions arise: What is the annual volume expressed in dollars? How many transactions will be processed per year? If card acceptance is replacing cash payments, then a government cash manager would project a small percentage of payments by credit card in the first year, with the percentage growing in subsequent years as awareness of the credit card option grows. Each government will have specific circumstances that would influence actual participation rates. Regardless of the eventual participation rates and transaction volume, “break points” should be negotiated along a scale of projected volume at the time of contract negotiations.

Pricing Structure. Credit card transaction pricing is not transparent. Acquiring banks work hard to find the best compromise between passing through their costs with reasonable mark-up and providing merchants with rates that are understandable, easy to track, and easy to report. The major portion of the fees paid by a merchant are the “interchange” fees which the acquiring bank pays to the cardholder's issuing bank, as established by the system provider (e.g., MasterCard or Visa).

The interchange fee structure is designed so that every transaction is priced independently. The price is based on as many as 70 criteria, including the following four basic criteria:

• What type of card was used;
• When the transaction entered the provider's system;
• The dollar value of the transaction; and
• How the transaction entered the provider's system.

  At the time a government establishes a credit card acceptance program, it is possible to estimate into which category most transactions will fit. Even so, that estimate will rarely be 100 percent accurate in application.

  Furthermore, at the time an acquiring bank submits a transaction to the system provider for settlement, the interchange fee can still only be forecasted. When the system provider completes the transaction, the acquiring bank's forecasted number is used. Within another two days if the transaction did not meet all of the criteria for the forecasted interchange rate, another rate needs to be charged, so the system provider charges the acquiring bank with an adjustment for the difference in interchange fees. Obviously, all of the “days” indicated here are business days and continue regardless of calendar dates, such as the last day of a month.

  Because of the complicated method of pricing transactions, it is difficult to provide accurate pricing and reporting to merchants on a timely basis. Additionally, the reporting is often difficult to present in a manner that is easy to understand. Contracts are often written in such a way that it looks like all transactions will be processed at the lowest interchange rate, but exceptions occur and higher rates can apply (often buried in contract provisions). Some vendors charge the higher rate and an additional fee for charging the higher rate; many acquiring banks do not charge an additional fee. Reading all paragraphs of a proposal and the proposed contract is very important to ensure complete understanding of all of the fees to be charged.

  Bundled versus Unbundled Pricing. Is it better to pursue bundled or unbundled pricing? The answer depends in large part on the size and breadth of the program. For large programs (greater than $1 million per year), unbundled pricing makes sense. In this case, unbundled pricing means paying directly for interchange fees plus a flat per-transaction fee. Using this approach, interchange fees are passed through “at cost” (a non-negotiable cost) to the system provider (e.g., routed through the government's card processing vendor to MasterCard or Visa), and each transaction will cost a certain number of pennies each (e.g., a payment to the card processor not passed on).

  For very small programs (under $100,000 per year), bundled pricing makes sense. Let the acquiring bank estimate the total overall interchange rate: the dollar amount at risk to the government is minimal and the ease of administration and oversight is greater. For either approach, the only way to determine a competitive rate is to speak to other merchants of a similar size. Whether these merchants are in the government sector or in the retail sector, it helps to get a perspective on prevailing rates.

  Equipment. At the time of this writing, a single credit card terminal with a printer can be purchased for less than $750. Only your government can make the determination regarding lease/buy decisions; however, some equipment has been overpriced in the past simply because the buyer did not compare prices. Major office supply stores sell card acceptance terminals and comparing these prices to those paid by other agencies is helpful baseline information.

  Service. When negotiating for credit card acceptance services, customer service is an important differentiator among firms. Several measures can be taken to gauge quality: (a) ask for customer service phone numbers; (b) determine escalation procedures when satisfaction has not been reached; (c) call the service number and talk to a representative. By doing the latter, governments may get a sense of the customer service representatives' attitude and competence and the overall quality of service that can be expected if the government establishes a relationship with the firm. Not all vendors offer extended hours (e.g., “24/7”) of customer service.

  Training. Today's card acceptance equipment is relatively simple to use and most vendors provide telephone training for their customers. This training is often available whenever it is needed, not necessarily just at the time of installation. However, for large programs, there may be appropriate times to request hands-on training, particularly if there are significant issues with closing out batches at unusual times. A government would need to identify its needs and specify requirements accordingly.

  Reporting. Reports and reporting formats vary widely, just as the pricing configurations do. It is advisable that governments obtain a week of sample reports. Ideally, a vendor will explain the various data fields, and demonstrate how to reconcile a week of statements. Some vendors offer online reporting down to the transaction level. Others simply offer monthly summary statements. It is important for each agency to determine its own needs.

  Comparing Uncomparable Proposals. Vendors will provide bids with pricing that will be very difficult to compare. It may sound obvious, but read every item in the proposal carefully, because some of the contracts and proposals have pricing information in multiple places. Furthermore, it is not always clear how all the elements of the pricing will be implemented. The three most common methods are listed here:

  1. There will be a predetermined rate for all transactions. For any transaction that does not meet the requirements for the lowest interchange rate, the cost of the additional interchange fees will be passed through to the merchant. (These transactions that do not meet the lowest rate are often called “downgraded transactions.”)

  2. Each transaction will cost a predetermined amount (expressed as number of cents per transaction) and interchange fees will be passed through at cost.

  3. Each transaction will be charged one of three rates: lowest, middle, and standard. The vendor would determine which interchange rates are applied to which group but does not share any of this information with the merchant. This is a very simple program for the merchant and shares the risk of interchange accuracy with the merchant. For the very large government with high transaction volume, however, there is the potential to spend more on downgraded transactions than is necessary.

  If all proposals were offered in terms of interchange fees plus a transaction fee (method 2), it would be easy to compare pricing. Of course, that is not always the best pricing method for the merchant or the best vendor overall for the merchant. If the third method is offered, then interchange rates are not even offered at cost, complicating matters even further.

  The best way to compare bids is to create a sample scenario and apply the proposed prices to it. For instance, a standardized method could be imposed in the request for proposal as follows:

  1. Create a set of assumptions where there will be $250,000 of transactions on credit cards in a year and the average transaction will be $50. This results in 5,000 transactions per year.

  2. Develop another set of assumptions about how the transactions will be processed. For example, assume that 90 percent of the transactions will be swiped through the terminal at the counter, 7 percent will be key entered (typical of payments made over the telephone), and 3 percent will go through at the highest rate in the Visa or MasterCard Systems. It is valid to ask the vendors to confirm that these are reasonable assumptions.

  3. Apply the vendor's proposed bids using these assumptions and judge the results.

  If competing vendors have not given enough information to complete the pricing proposal, missing information can be requested or the proposal can be considered incomplete, depending upon on each government's procurement process.

  In conclusion, when negotiating a credit card acceptance agreement, governments should examine a variety of factors. Economic terms will be complex, because pricing is complex and is not always directly comparable. Customer service and other non-economic terms also will have to be assessed to round out the negotiation.

  Janet Langenderfer is senior financial associate-credit cards for the National Railroad Passenger Corporation (Amtrak).

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Interest rate forecast panelists

John Lonski John Silvia Carl R. Tannenbaum

Moodys Investor's Service Wachovia Securities LaSalle National Bank

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