Pricing of cheques and electronic payments

India seems to be now moving to a system where it costs the originator more to make an electronic payment than to issue a cheque. This is dysfunctional because the cheque imposes costs both on the receiver and on the payment system (the paying bank, the collecting bank and the clearing house). Of course, in a free market, banks are free to levy charges as they deem fit and charges do vary significantly across banks in India. What is interesting is (a) that the resulting market equilibrium is so perverse, and (b) that this perversity is a recent phenomenon.

In the past, many banks were not charging for electronic payments through the National Electronic Fund Transfer (NEFT) system operated by the Reserve Bank of India. Recently, more and more banks seem to be introducing charges at the maximum permitted rate of Rs 5 per outbound electronic transfer for small transactions. By contrast, most banks charge only about Rs 2 per cheque leaf, and the first 20-30 cheques per year are typically free.

This means that it may now be advantageous for many retail consumers to issue cheques instead of using NEFT for inter-bank transfers within the same city. This privately optimal decision does however have a huge negative externality. The cost to the paying and collecting bank of processing this cheque might be about Rs 50 each, and there are costs elsewhere in the system (for the payee who has to deposit the cheque and for the clearing house which has to process it).

What I would like to know is whether this pricing decision is optimal for the individual banks. Perverse as the end result is, the pricing can be rational for individual banks if customers sophisticated enough to use NEFT are assumed to be relatively price insensitive. In that case, the customers continue to use NEFT and the bank simply pockets another source of revenue. The alternative hypothesis is that the costing and transfer pricing system in many banks is badly broken. In that case, the costs of processing paper cheques is not fully reflected in the pricing decision, while the cost of the electronic transfer is a transparent out of pocket cost (the fee charged by NEFT). A naive cost-plus-pricing system does the rest of the mischief. It would be interesting to figure out which hypothesis is closer to the truth.

In either case, the problem can be solved by a Pigovian tax on cheques.

Posted at 8:29 pm IST on Sun, 6 Nov 2011         permanent link

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