Several credit cards are so rewarding that (1) banks are spending the entire amount of interchange on their customers, and (2) banks are losing money on the products.
Premium travel rewards is so competitive that banks may never earn back the cost to acquire a customer (acquisition bonus, plus related expenses). I’ve long argued that when the bank’s model shows payback in 7-10 years, what that means is that the person who built the model will no longer be the one managing the project when it comes time to see whether that prediction actually came true. Customers who keep cards for 5, 10 and 15 years as a whole turn profitable, but the acquisition cost to find those customers may mean that the product as a whole was a money-loser.
Saturday Night Live captured the phenomenon in their commercial for the ‘First CityWide Bank Of Change’. They lose money on every transaction, but make it up on volume!
For these cards the bet is that the bank will lose money on interchange, but make money on APR. They’re looking for customers who will revolve (but with premium cards they’re often attracting the customers least likely to revolve balances). Banks lose money on some customers (who pay off their bills each month) while making money on those who pay monthly interest charges.
There are other versions of this: card deals that pay so much to the co-brand partner, in terms of marketing fees and low credit card processing costs (think: the Citibank-Visa deal for Costco), that the bank is really buying an opportunity to lend to card customers and whether the deal works out depends entirely on how much consumers borrow.
A paper from Federal Reserve, IMF, and National University of Singapore authors is one of the first to look beyond interchange to find winners and losers in credit card rewards. And far from the naive story about cash customers subsidizing rewards credit card customers, they find that cross subsidies are actually from rewards customers who revolve to those who do not.
[W]e find that sophisticated consumers profit from reward credit cards at the expense of naive consumers who lose money both in absolute terms and relative to classic cards. We estimate an aggregate annual cross-subsidy of $15.5 billion. Notably, our results are not driven by income—while sophisticated high-income consumers benefit the most, naive high-income consumers pay the most.
A couple of interesting data points:
Reward cards account for over 80 percent of total credit card spending and for over 60 percent of all new credit card originations (CFPB, 2019). In 2019, the largest U.S. banks paid out $35 billion in credit card rewards.
Interchange aside, those $35 billion in card rewards compare to approximately $100 billion in card interest and fees.
Since banks are looking for customers who will borrow, and to find those customers they also need to find customers that don’t (and they can’t really fire those customers), those who don’t borrow get a great deal – one that in their specific case banks may even lose money on. Banks are looking to make money on a portfolio basis, rather than on each individual customer. But that doesn’t really mean there’s a subsidy, per se. And it doesn’t mean borrowers are losers since they may have a need to borrow. The loss, for them, comes in when they’re taking a less good deal for borrowing than they could otherwise achieve when doing so through their rewards products.
The lesson here is the one I outlined years ago: this game is only for you if you pay off your cards in full each month. It’s easy to moralize and say you shouldn’t carry a balance, but there are customers who need to repair their car to get to work or otherwise smooth their income against necessities and credit cards are a superior form of borrowing compared to the next-best alternative some customers face like payday loans. If you’re someone who uses cards for borrowing, though, you’re best off focusing on borrowing costs (like interest rate, and no fee 0% balance transfer offers) rather than rewards and certainly calculating the net expense.
(HT: Tyler Cowen)
The scheme of credit card rewards is an inefficiency in our money and banking system. Unfortunately our would-be saviors in cryptocurrency have been set back.
Wow! Here’s the last line of the abstract;
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Who Pays For Your Rewards? Redistribution in the Credit Card Market
68 Pages
Posted: 7 Jun 2022
Last revised: 2 Nov 2022
Sumit Agarwal
National University of Singapore
Andrea Presbitero
International Monetary Fund (IMF)
André F. Silva
Board of Governors of the Federal Reserve System
Carlo Wix
Board of Governors of the Federal Reserve System
Date Written: October 31, 2022
We estimate an aggregate annual redistribution of $15 billion from less to more educated, poorer to richer, and high to low minority areas, widening existing spatial disparities.
This is pretty much the opposite of what your post claims.
Nothing is free. Somebody pays. Always.
Your piece sounds like a bit of an over-simplification to me. Credit cards are a huge market which is highly segmented.
Obviously, credit cards that primarily target revolvers enjoy higher yields than those after transactors. But revolvers are higher risk and have substantial charge-offs and lead to a bunch of other costs.
Ultimately, there are hugely differently structured credit cards. Even if we limit ourselves to the reward cards segment, far from all cards are looking for revolvers
Always pay my accounts in full. Will not let the banks get anymore money from Me.
“We estimate an aggregate annual redistribution of $15 billion from less to more educated, poorer to richer, and high to low minority areas, widening existing spatial disparities.” —. Any comment on that?
Again, I think it’s academics asking the wrong questions. We know that (in the low-interest environment that’s behind us) banks needed a 1% spread to cover costs, perhaps a 2% spread to make a non-trivial profit. Ofc, taking cheap money like deposits and giving it to lowest-risk prime borrowers. Why shouldn’t you be able to put off something similar with high-quality transactors doing CC business?
Clearly, you can make money with revolvers, too. But your business model is going to be way more complicated. You’d be looking at APRs, monthly payment rates, fees (late-payment fees etc.), deliquency rates, charge-off rates; most likely, you’re gonna be refinancing the revolving loans using financial markets. Much higher yields, but much higher costs and substantial risks.
It is true the big banks won’t make money back from these annual fee cards. Too many customers will cancel once the juice isn’t worth the squeeze of another annual fee. Most smaller banks don’t offer big sign up bonuses for this reason. Cardless offered good ones at inception to build rapport using this miles and points community to that end. I thought the founder was inept as he was a miles and points guy who knew the economics of big sign up bonuses. Now Cardless has removed those big sign up bonuses and has focused on marketing to less knowledgeable sports fans with the travel card as the one exception currently. He just used us to get good reviews from trusted people which served us in the miles and points community well.
The big banks probably do better with the cobranded cards as they can buy miles at a discount and the brand benefits keep clients paying the annual fee for many years. One aspect of cards for big banks not considered is it is a marketing cost. Instead of spending money advertising the bank, deposits, brokerage, loans, and etc. they can advertise this great premium credit card that’s aspirational. It builds brand awareness and they can cross sell mortgages, brokerages, and deposit products by mail or email.
It’s really the travel cards and Amex charge cards that don’t make economic sense. The $200 bonus on the Doublecash is profitable for the bank much quicker. The $800 minus fee on the Premier which someone will cancel next year is not.
And then there are the zero percent offers that bet folks won’t pay off the full balance by the offer term.
I do. Just made two major purchases on 0% for 9 months… and have already allocated the payments for the term to pay off. Why put out that cash now and miss months of other earnings?
The naive are those like you who spout, for obvious self-serving reasons and conflicts of interest, that in the US cash payers aren’t subsidizing the 2.5% that credit card users cost merchants.
And the paper agrees, and even expands on this:
> credit card rewards are a potential channel that can exacerbate existing socio-economic disparities across regions in the United States, as they imply a transfer from less to more educated, from poorer to
richer, and from high- to low-minority areas, thereby widening existing spatial disparities
I hope Congress finally legislates this racket away similarly to what the less corrupt governments in in Australia/New Zealand and, to a lesser extent, the EU have already done.
Heh, heh. He said “marketing fees”.
@Jake
Of course it is self serving. It serves everyone for credit card rewards to exist. Consumers benefit greatly, small businesses have the option of charging a 3% fee which they do in Pizza shops in NYC, bigger businesses get more spend from people who don’t want to use debit or don’t have cash, and shareholders of banks do ultimately earn a decent return because they still make banks money overall through cross selling and marketing other profitable services. Europe really is in the Stone Age when it comes to credit, financing, rewards, and banking. There is a reason the median household income in Germany and France is €31000 vs $62,000 in the U.S. It’s not just taxes, socialism, and regulations but also a lack of access to credit and things which are common here.
Agree to the benefit of paying off each month, there has also been commentary on these pages that if you always do so some issuers will in fact fire you as a customer and not renew.
You nailed it @John Dogas. I’ve personally met ppl who LEFT Europe to come to the US exactly for those reasons.
And for those like many of us adept of reading blogs on this topics, we can read the frustration ventilate everyday for those without access to the wonderful US banking/credit system (myself included while I was in my homecountry, and then in Panamá were I had partial but flawed access).
I bet $100 that Jake is a left wingnut who is of course absolutely clueless of the wealth generating intricacies you neatly described. They all hate progress and freedom with their guts.