Who pays in the credit card business?

Cross-posted from DFA Blog.

Today we continue our series on credit cards, looking at the economics of the business on a customer segment basis. We are using data from our household surveys, as well as industry cost and revenue benchmarks we maintain. This is segmented analysis, because consumer behaviour has a profound impact of the profitability of the business. In our client work we will segment the market down to twenty segments, or so, but today we will use a more basic three-way cut.

So, lets introduce segmentation, based on card use. We see Transactors, who pay off their balances every month without incurring interest charges; Infrequent Revolvers and Constant Revolvers. The average balances, and the balances on which they pay interest varies. We find that a high proportion of Constant Revolvers are struggling financially.

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We can then look at their transaction patterns. Transactors are the most active card users, and the most likely to be enrolled in a rewards programme, collecting points as they go. Transactors will do all they can to put as much traffic through their cards to collect the “free lunch”. The other segments tend to use their cards less, and may not be enrolled into a loyalty scheme.

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We then need to understand the transaction flows and fees in the system. Whether the card is an open scheme, like Visa or Mastercard, or closed like Diners and Amex, there are a number of elements to consider. Cards are issued, and bear an annual fee. Interest is charged on outstanding balances, after any interest-free period. Overseas transactions and cash withdraws will incur additional fees. At the merchant end, they will have a terminal provided by a bank, will incur merchant service fees when they accept a transaction, and some may charge a service fee (the regulations charged here recently, but some still charge the customer at point of sale). The bank issues a card, processes the transactions, generates statements, handles disputes, and frauds. All this costs.

So, we can look at the economics from the point of view of the main players. Households will pay for the card, but the most significant element is interest charged. So, no surprise then that Constant Revolvers are paying the most, and in fact will subsidise everyone else.

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From a merchant point of view, they pay the banks to receive transactions, which helps them to sell their goods. Merchant surcharges offset some costs, but there is a net cost to the merchant to receive card payments. Online transactions may cost less.

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From a bank point of view, they make very little from transactors who have a rewards scheme, as loyalty is a net cost to the bank. A typical transactor will just about break even, if they use their points. [Actually about 50% of points are never claimed, so the banks can make a little more]. Constant Revolvers are significantly more profitable, typically worth more than $1,000 a year.

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So the credit card business relies on those who continue to revolve to maintain the value of business.

Two other closing thoughts. First, banks hold vast volumes of credit card transaction data which can be mined to profile customers, some are waking up the the potential value of this information asset. Second, our segmentation enables us to identify which types of household more most likely to be in the Transactor or Revolver groups. Not surprisingly, this can lead to marketeers trying to devise strategies, like zero balance transfers to attract more of the most profitable customers. No surprise then to see a number of offers in the market at the moment. They can usefully reduce interest, but only if the balance is paid off before the expiry. New transactions will often incur standard interest charges, which are quite high at the moment.

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Comments

  1. rob barrattMEMBER

    I worked as a ‘consultant’ for a very large credit card issuer in the UK for a year. In effect, as a Business Analyst. My job was to evaluate the impact across the business of introducing “usage fees”. In practice this was a non-usage penalty, if you didn’t spend enough you got hit by a fee. Say no more.
    How did they determine what interest rate to charge?. Every month or so they would scan the profiles of their borrowers looking for a particular group of people they could up the interest for. This might be people who were revolvers with a particular range of debt that indicated a bit more interest wouldn’t cause a run off. They used credit reference agencies like Experian to find out as much as possible about the person.The only group of people immune from this process were the people on the VIP list, this was made up of people who were influential, celebrities etc. who could cause trouble. In effect, this resulted in multiple groups of people, all with an identical looking credit card, paying vastly different interest rates. The cards held 3 internal balances: balance transfer, merchant (i.e shopping) and cash withdrawal with different interest rates. When you paid money back at the end of the month, it was always credited to the balance with the lowest interest rate to keep the high rate balances as high as possible. Nice.

  2. Thanks for the report, the $1000 a year in interest cost is an eye opener. One question though : shouldn’t the operating cost be the same for all 3 groups?

    • Martin_DFAMEMBER

      Hi, no, the operating costs relate to the internal costs within the bank, people, computers, and a share of head office. So they should not appear in the household or merchant views.

  3. This statement, “they make very little from transactors who have a rewards scheme,” implies that the bank makes at least some profit from transactors.

    That is a contradiction to this statement, “Constant Revolvers … will subsidise everyone else.”

    Revolvers may be the main source of profit for the bank but that does not mean they are subsidising the Transactors.

    • Martin_DFAMEMBER

      Hi, not so, as a business would be expecting to make a return of say 10-15%, if you add the profit element, Transactors do not activate rewards do not break even, if they claim rewards, they are well under water. There is cross-subsidisation.

      • You shouldn’t be including a profit component if you are saying that one customer is subsidising another. “Subsidising” implies that someone is getting a product or service for less than cost-price.

        not so … There is cross-subsidisation.
        I’m just going by the information in the above article, which says that the bank makes money even from transactors… “A typical transactor will just about break even, if they use their points. [Actually about 50% of points are never claimed, so the banks can make a little more]” I suspect they make their money from processing fees charged to merchants. If you want to say that merchants are subsidising transactors I think you’d have a case, but not for claiming that revolvers are subsidising transactors.

        Do you have some information other than that presented in the article? Because nothing in the article says that there is cross-subsidisation other than the throwaway line, “Constant Revolvers … will subsidise everyone else.”

    • Obviously the banks never know whether a card holder would become a constant revolver. That is why they want to take on board everyone and then …. life will show. But the already established revolvers are a sweet catch with the zero interest rate.

  4. two plus twoMEMBER

    Something else to consider: I fall into the transactor category and probably cost the bank even more as I keep at least the monthly balance of my credit card in an interest bearing account. On the second last day of the credit card period I pay off 100% of the credit card balance. Interest rates are of course fairly low at the moment, but I am still constantly generating interest on ‘borrowed’ money on my credit card from each month’s purchases in addition to the loyalty points.

    Would be a similar effect for mortgagor’s with offset accounts.

    • Something else to consider: I fall into the transactor category and probably cost the bank even more as I keep at least the monthly balance of my credit card in an interest bearing account.

      How do you get the money out of the credit card to put into the savings account ?

  5. two plus twoMEMBER

    Apologies if I mislead: I only get the money out by spending.

    For my credit card (I’m sure most are similar), purchases take up to 55 days to incur interest – 30 statement days then 25 days to pay off the closing balance. So you could get goods/services now, earn interest on the purchase cost for up to 55 days, then pay the card off on the last day, potentially earn up to 0.68% interest on the purchase (plus generate loyalty points)… All adds up over the course of a year. Just have to make damn sure to pay off the credit card balance on time.

    • Ah, OK, I thought you were doing something like this (which I intend to in the near future):

      1. Use one of the myriad 0% balance transfer offers out there to “pay” a substantial sum (say, $30k) off your credit card and drive it into credit.

      2. Move that “credit” into a high interest savings account or mortgage offset (either via a direct electronic transfer, or with ATM cash withdrawals and deposits).

      3. When the 0% balance transfer period runs out, balance transfer it onto another card.

      4. Lather, rinse, repeat until you can’t balance transfer anymore because they’re onto your game, then pull the money out of the savings or offset account to pay off the last card in full.