Reader George asked about the economics of rewards credit cards.

I was just mulling over the economics of credit card bonusing last night- are all of the costs absorbed by the credit card companies?

2x travel and dining are broad credits that capture a big chunk of credit card spend, so that’s a subsidy that makes sense. But 5x at office supply houses, or 5x on the Freedom categories?

The bonuses drive a lot of incremental traffic into those stores (albeit low margin gift cards, etc)- do the stores pay advertising fees or a higher credit card fee on these transactions to offset the cost?

What about the privileges on premium cards, like IHG Rewards Club Platinum status and free nights on card renewal – does Chase pay the cost, or does IHG comp it to them, because Chase buys so many IHG points already?

Generally speaking, credit card companies pay for the benefits they provide to cardmembers. An airline or co-brand partner gets paid not only for the points sold to the credit card company, but also for the perks.

There may be a few posts I’ve written that are of interest here:

• The Secret Sauce Behing Putting Together Co-Brand Credit Card Deals
  
• Why Credit Card Companies Waive Foreign Transaction Fees
  
• Understanding Your Credit Score Can Be Worth Millions of Miles and Real Cash
  
• The Economics of Airlines’ Mileage Addiction

The specifics of each deal are held in confidence, although they do make it into the public occasionally — for instance, SEC filings disclosing how the payments from banks to loyalty programs are accounted for. And when these deals become the subject of lawsuits (such as when Bank of America sued over Juniper Bank becoming the exclusive issuer of US Airways cards when US Airways and America West merged) the full, lightly redacted contracts become public. They aren’t fascinating reading for everyone, but they are for me!

It’s not entirely that simple, because the overall deal that a loyalty program and a bank strike (in conjunction with the payment network) is a complex negotiation that winds up with a total deal cost and value. How the funds are assigned to each element of the deal may wind up being somewhat arbitrary or based more on the accounting desires of each entity than anything else — for instance what revenue a loyalty program can recognize right away from the sale of miles, versus what they need to defer against the cost of future travel redemptions.

Here’s what I mean. Take the free checked baggage benefit that many airline cards come with. Credit card companies offer this because checked bag fees really get under travelers’ skins, so having an ‘out’ from paying these fees does a great job at prompting credit card signups. Card companies, under their co-brand contracts, pay for the checked bag fee waiver. And airlines book that revenue in the current year rather than booking a deferred liability. So the airline has an incentive to overweight the value of the checked bag benefit, in order to benefit their bottom-line now.

The credit card company pays the hotel program for an annual free night benefit. It’s at a discount compared to the number of points a similar redemption would cost, because the free night expires and so there may be breakage. The free night category is capped in order to further reduce the cost of that night to the bank.

The reason the annual free night is offered is as a way to encourage cardmembers to keep the card, instead of cancelling — it convinces them they’re getting something of ongoing value in exchange for paying an annual fee.

Premium rewards cards cost merchants more in fees than generic Visa or MasterCard products. But the payment networks are part of the negotiation, they offer cut-rate processing overall or for specific merchant categories to help the bank and loyalty program fund the rewards that the card offers. In that way, Visa or MasterCard expects to get more charging volume than they’d otherwise receive. And the bank sees a lower cost to provide the rewards.

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