Sunday, August 13, 2006
Profits and losses
Costs
Credit card issuers (banks) have several types of costs:
Interest Expenses
Banks generally borrow the money that they then lend to their customers. As they receive very low-interest loans from other firms, they may borrow as much as their customers require, while lending their capital to other borrowers at higher rates. If the card issuer charges 15% on money lent to users, and pays 5% on that same amount, they are essentially making 10% on the loan. This 5% difference is the "interest expense."
Operating Costs
This is the cost of running the credit card portfolio, including everything from paying the executives who run the company to printing the plastics to mailing the statements to running the computers that keep track of every cardholder's balance to taking the many phone calls which cardholders place to their issuer to tracking down fraud rings to protect the customers. The expenses involved in taking phone calls from customers are usually the greatest of these categories.
Charge Offs
Some customers never pay their credit card bill. In any given year, anywhere from 4% to 9% of the money that a bank lends to its credit card customers will never be repaid. Some credit card issuers have had various troubles and have seen this number rise to over 20%. As this number climbs or becomes erratic, officials from the Federal Reserve take a close look at the finances of the bank and may impose various operating strictures on the bank, and in the most extreme cases, may close the bank entirely.
Rewards
Many credit card customers receive rewards, such as airline miles or cash back, as an incentive to use the card. Rewards are generally tied to spending money on the card, which may or may not include balance transfers, cash advances, or other special uses. These rewards rarely cost credit card issuers less than 0.25% or more than 2%, and in fact will usually run in the 0.5% to 1% range, as a percentage of purchases.
Fraud
Where a card is stolen, or an unauthorized duplicate made, most card issuers will refund some or all of the charges that the customer would have otherwise received, for things they didn't buy. These refunds will in some cases be at the expense of the merchant, especially in mail order cases where the merchant cannot claim sight of the card, but in other cases, these costs must be borne by the card issuer. The cost of fraud is high; in the UK in 2004 it was over £500 million [1]. Credit card companies generally guarantee the merchant will be paid on legitimate transactions regardless of whether the consumer pays their credit card bill.
Revenues
Offsetting costs are the following revenues:
Interchange fees
Interchange fees are charged by the merchant's acquirer to a card-accepting merchant as component of the so-called merchant discount fee. The merchant pays a merchant discount fee that is typically 2 to 3 percent (this is negotiated, but will vary not only from merchant to merchant, but also from card to card, with business cards and rewards cards generally costing the merchants more to process), which is why some merchants prefer cash, debit cards, or even checks. The majority of this fee, called the interchange fee, goes to the issuing bank, but parts of it go to the processing network, the card brand (American Express, Visa, MasterCard, etc.), and the merchant's acquirer. The interchange fee that applies to a particular merchant is a function of many variables including the type of merchant, the merchant's average ticket dollar amount, whether the cards are physically present, if the card's magnetic stripe is read or if the transaction is hand-keyed, the specific type of card, when the transaction is settled, the authorized and settled transaction amounts, etc. For a typical credit card issuer, interchange fee revenues may represent about fifteen percent of total revenues, but this will vary greatly with the type of customers represented in their portfolio. Customers who carry high balances will have low interchange revenues, while customers who use their cards for business and spend hundreds of thousands of dollars a year on their cards will have very healthy interchange revenues.
Interest on outstanding balances
Customers who do not pay in full the amount owed on their monthly statement (the "balance") by the due date (that is, at the end of the "grace period") owe interest ("finance charges"). These customers are known in the industry as "revolvers". Those who pay in full (pay the entire balance) do not. These customers are known in the industry as "transactors" or "convenience users". Interest charges vary widely from card issuer to card issuer. Often, there are "teaser" rates in effect for initial periods of time (as low as zero percent for, say, six months), whereas rates for those with poor credit can be as high as 30 percent (annualized) or occasionally more. In the U.S., rules governing interest rates are set at the state level; some banks have chosen to establish their credit card operations in states such as South Dakota that have less restrictive limits on interest rates. See Usury laws.
Fees charged to customers
The major fees are for (1) late payments; (2) charges that result in exceeding the credit limit on the card (whether done deliberately or by mistake); (3) Returned check fees or payment processing fees (eg phone payment fee); (4) cash advances and convenience checks (often 3 percent of the amount); (5) transactions in a foreign currency (as much as 3 percent of the amount; a few financial institutions charge no fee for this -- it is worth noting as an aside that the credit card issuer charges a fee on top of the international bank rate when converting currency, which in most circumstances is a better rate than is available elsewhere, even with the fee added on); and (6) membership fees (annual or monthly), sometimes a percentage of the credit limit.
