Cross-subsidised by credit card ill-discipline

Benje Patterson decided to discuss the incentives he faces when deciding to whip out the credit card to pay for purchases (Infometrics link).

After discussing the benefits he gets from different rewards schemes he points out:

These benefits sound too good to be true, but they really aren’t, so long as you maintain the same spending discipline as our model couple.

But if you aren’t so disciplined (and banks really hope that you are not), then your credit card can quickly change from being a wealth-enhancing device to a real drag on your pocket.

But of course, at his individual level, and given his disciplined use of his card:

But why should I care? So long as banks can continue to profit from these hordes of people with interest-bearing credit card balances, then the status quo remains.  As a result, people like me can keep freeriding and enjoying the benefits of sensible credit card use!

  • John Small

    Its certainly true that the banks do well out of those who end up paying interest on credit cards. But don’t forget the revenue that comes in from the other side of the platform. Much of the largess the banks shower on cardholders comes from the transaction fees paid by merchants.

    • Indeedy! We chatted about that at work, and the feeling was that it would be best to focus on only one issue at a time.

      I find the idea that, if merchants aren’t allowed to pass on costs to credit card users, they will end up increasing prices and making “non-users” cross-subsidise to be pretty interesting as well – as mentioned here:

      • “if merchants aren’t allowed to pass on costs to credit card users”

        From memory this is no longer the case in NZ.

        • Indeedy, was more just trying to note that we appreciate we are only looking at one element of a complicated issue 😛

  • Donal Curtin

    Will Taylor’s comment, that merchants can now surcharge for cards, is correct. It was one of the outcomes of the Commerce Commission’s settlement of the ‘interchange’ case against the credit card operators, though the main one was that the banks were now required to act as competitors for merchant business, rather than posting a collective price.
    John’s comment is also absolutely on the money: this is one of those two-sided platforms par excellence (it’s even arguably a three-sided market), and as he says the big lesson from those markets is you have to look at all sides at once to see the full picture.
    Incidentally, while there’s any amount of moaning about credit card interest rates, it’s not the full story. I remember being barracked about this when I gave a speech to a Probus Club when I was chief economist for one of the banks. “Why do you think you can get away with these extortionate rates??”, one person in the audience shouted at me. “Because you’re prepared to pay them”, was my answer. And to their credit the audience burst out laughing.

  • Andrew F

    As someone who has examined credit card models in some detail, I confirm that a large chunk of their revenue does indeed come from the merchant fee. The interest is arguably the icing on top. Of course, much depends on how the card company (not all cards are issued by banks, especially overseas) selects their card holders. If they take a shotgun approach, they will expect poorer card servicing and thus will accumulate more in interest payments but also at the same time suffer higher write off rates. In contrast, selecting better “credit risks” means fewer (and less) late/interest payments and fewer write offs.

    • Andrew F

      So I guess I should conclude “Yeah nah”. If everyone paid up monthly banks would not reduce the benefits to card holders. The benefits tend not to be cyclical. Sure, airlines are more likely to go bust during downturns (so those airpoints are not riskless forms of storing value) but generally rewards systems don’t get rejigged according to where in the credit cycle the economy is. On the other hand, interest payments and late fees are highly influenced by the status of the economy. So it would make no sense to try and balance these two and from my experience, the card issuers don’t.

      As an aside, as Donal points out, interest rates on cards are not tied to any cost of funds (except in an extremely loose way i.e. if overnight rates went up to 20% you can be pretty damn sure card borrowing rates won’t stay at 20-25%) and it may be more appropriate to see the rate as a form of private stupidity tax. While you can be sure that a segment of the population are going to be stupid, structuring a card business (or any business) on that assumption is very risky (think legislation or social media campaigns). And believe you me, card companies employ some very smart cookies.