Better living through plastic

Or how I learned to stop worrying and love the card

I understand that people do not like credit card companies.  Most people feel about credit card companies the way they feel about their boss: “life would be so much better if they just thought about me before themselves!”

The problem with this type of thinking, however, is that it’s myopic.  Your boss, (and your credit card company for that matter), have other things to worry about: other coworkers (other cardholders); meeting objectives (profits); and their own bosses (their shareholders).  You are but one cog in an immense machine.

As Congress, in it’s laughably finite wisdom, has decided to vote on the “Credit Cardholders’ Bill of Rights”, I thought now might be a good time for an overview of that immense machine, how it works, and the other cogs you should know about.  As I’ve mentioned before, I work in the industry, though not for a bank, so take my opinion as informed (and a little biased).

In general terms, the various provisions being considered by the Senate include restrictions on the card issuers, the card processors (interchange) and merchants.  You’ll notice that one cog is missing from that list (cardholders).

This is the equivalent of your boss taking away the fridge because someone keeps eating other people’s lunches.

The regulations would restrict the ability of card issuers (banks like Citibank, Chase, Capital One, Bank of America, etc.) to change your interest rate, close your account or take other adverse actions except in certain, narrow circumstances.  As I’ve noted before, this will lead to an increase in the average interest rate; the disappearance of 0% teaser rates; and, for some, the complete removal of access to credit.   Put simply, this is the equivalent of your boss taking away the fridge because someone keeps eating other people’s lunches.  When banks cannot single out bad credit risks, everyone has to pay a higher rate.

The second cog in this machine is the card processors.  These are the companies (MasterCard, Visa, Amex, Discover, etc.) that process the credit card transactions and set the discount rates (interchange).  Let me explain.  MasterCard and Visa have what is called a four-party model.  There is you (the cardholder), your bank (the issuer), the merchant and its bank (the aquiror).

The system works like this: you have a contract with the issuer, who extends you credit (or provides a deposit account for debit).  For credit, your contract says the issuer will authorize you to borrow up to a set amount and, if you don’t pay in full every month, you will pay interest.  The issuer sets your interest rate after considering the risk that you will (or won’t) pay.

None of this is free; nothing worthwhile ever is.

The merchant has a similar (but opposite) contract with the acquiring bank.  The acquiror provides the merchant with credit card terminals and a bank account.  Each time someone uses their card, the terminal sends the relevant information through the card processing network.  At the end of the month, the acquiror deposits the amount into the merchant’s account.

Of course, none of this is free, nothing worthwhile ever is.  If you buy a $100 sweater, the merchant does not receive $100.  The acquiring bank deducts an amount (called the merchant discount or interchange fee), which varies based on the type of transaction, the amount, they type of card (platinum versus standard) and other variables.  That fee is typically about 2% for credit cards.  So your merchant gets about $98.

What about the other $2?  That is split between the issuing bank and the acquiring bank.  The amount of the discount and the split between the banks is set by the card processor (MasterCard, Visa, etc.).  The split is, generally, a function of the risk involved for the parties.  The issuer has greater risk in that, if the consumer doesn’t pay the $100, they will be out money.  The acquiror only has the risk that the issuing bank won’t pay.  (That used to be near zero, though nowadays, even banks go broke).

Incidentally, have you ever wondered how banks (or Amex) can make money when you pay your bills on time every month?  Interchange is how.  It allows the banks to make a profit without charging you interest.  It also allows banks to offer rewards points, sweepstakes and other marketing promotions for you and the merchants.

So what does the merchant get out of this?  If you’re older than 35, you probably remember more armored trucks on the road and more surety bonds.  In the “old days”, cash was far more prevalent and merchants had to make more bank deposits and bond more cashiers (cash is king, but it’s also portable).   Cashiers also had to spend more time reconciling the registers, counting change and breaking large bills.  Not to mention check kiting scams, counterfeit bills and other simple forms of fraud.  And that’s just for small purchase merchants.

For appliance and department stores, you had additional costs in providing customer credit.  Whole divisions of retailers were created to deal with getting the right customers the right credit, and it had to be repeated for each purchase.  In addition, the risks were greater because larger purchase amounts meant larger bills and increased fraud, which pays better on big ticket items.   On top of all of that, cash and credit cards don’t tell you anything about your customers.  Credit card companies can tell you about spending habits, return customers and cross promotions.  With credit cards, the cost of doing business has gone down for merchants, and 2% is a small price to pay.

You get a new bicycle for your kid, groceries, a trip to Tahiti and the brakes on your truck fixed.

So what do you get?  You get access to a large and flexible line of credit that you can access in nearly 30 million places all over the world, in every currency imaginable.  Your transactions get approved in about 1/10th of one second over a secure network that spans the entire globe.  You get fraud protection, peace of mind when you lose your wallet, cashback or points on purchases, travel insurance, emergency cash and literally thousands of other benefits.  You get a new bicycle for your kid, groceries, a trip to Tahiti and the brakes on your truck fixed.  You get all this with a 3⅜” x 2¼” piece of plastic:

Now go tell your boss you appreciate them.

Tags: Analysis, Business, Congress, credit cards, economy, law, money

This entry was posted on Thursday, May 14th, 2009 at 12:52 pm and is filed under Best Of, Business, Government, Opinion. You can follow any responses to this entry through the RSS 2.0 feed.