How credit cards make money
How credit cards make money
Patrick McKenzie (patio11) •
Nov 5th, 2021
Payments are deceptively complicated—everyone has used them and thinks they have good intuitions for how they work. However, payments require coordination of a dance between different parties who have extremely different incentives, both on a transaction-by-transaction basis and what they get out of participating at all.<br>Consider the humble credit card. Swipe it. Tap It. Dip it. HTTP GET it. You have probably used one, mostly oblivious to how it is a complicated bundle of services with a pricing structure strictly more complicated than a venture capital fund’s.<br>Here is how your bank thinks about it. (A useful jargon word to know: if you have plastic with your bank’s name on it, that makes the bank the issuer of that card. This helps to distinguish it from the other banks involved in a credit card transaction.)<br>Bundling and unbundling
It’s a truism that there are two ways to make money in financial services: bundling and unbundling. Credit cards aren’t just a bundle, they’re a Mandelbrot set of bundles. The bundles contain bundles. It is bundles all the way down… and all the way up.<br>One way to think of bundling is as cross-subsidization: you can charge users (or other parties, but we’re getting ahead of ourselves) more for X to give them Y for less than they expect, or even free (or negative!) Credit cards are cross-subsidization engines, both within a particular card as used, within a portfolio of customers using a particular card, and across a financial institution’s customers.<br>This last bit is very important: sometimes credit cards make money by losing money on the card itself. This is fairly rare, and mostly limited to a small number of issuers at the higher end of their product lines and customer archetypes. You can lose money on e.g. a particular entrepreneur’s personal rewards card to capture their deposit banking business, mortgage, and business banking, and while most financial institutions don’t set out to do this, individual accounts being single-product losers within large portfolios of users is unexceptional and very, very planned.<br>But let’s talk about the vastly more common case cards are designed around, where a good-fit, non-fraudulent user is expected to pull their own weight revenue-wise.<br>Revenue levers for credit cards<br>Net interest. Interchange. Fees. Marketing contributions. There, that’s (just about) every way your card can make money. Taking them in turn:<br>Net interest<br>Credit cards facilitate high-frequency minimal-human-involvement extensions of relatively tiny consumer loans bundled (ba dum bum) into an ongoing relationship with parameters negotiated very infrequently relative to individual transactions.<br>It’s often forgotten, but prior to credit cards, many Main Street retailers like e.g. pharmacies maintained hundreds or thousands of credit accounts for customers individually, necessitating their own back offices, accounting, and collections headache. This was in the ultimate service of getting customers to choose them over competitors, transact in larger sizes, and come back more frequently, the “only three aims of marketing.”<br>Credit cards represented banks saying: “You know, if you had a specialist doing that for you, it would be much more efficient. They’d have computers doing the math, not bookkeepers. They’d have departments doing collections, not clothing salespeople worried about offending customers who they’d need again at Christmas. They’d have access to cheap deposits to fund loans, rather than expensive working capital. They’d be adequately capitalized against losses, rather than having tiny margins backed by almost no equity, like most retailers. They’d diversify against regional and sectoral risk, rather than being all-in on the plant down the road still being open.”<br>So credit cards generate loans. A lot of loans. The traditional business of banking makes money on loans by funding them with a mix of cheap deposits and more expensive equity, charging adequately, collecting a spread, and using a portion of that spread to pay for operational costs and defaults.<br>Credit cards made the business of making loans work much better, by encouraging loans to be automated (rather than bespoke), by encouraging them to be more frequent, and by making them be iterative games rather than one-shots. This, and credit cards’ other revenue streams, let banks relax the “credit box” for loans originated by cards versus comparable unsecured signature loans.<br>The credit box, a metaphor from consumer underwriting, is conceptually a matrix which maps customer quality, loan amount, and similar to the prices you’d need to justify the underwriting decision or an outright denial, representing “This loan is negative expected value at all conceivable prices and we shouldn’t make it, at all.” Relaxing the box means approving more customers, approving smaller (less lucrative) and larger (riskier)...