In this article, we try to understand the profit and loss of the credit card issuing companies. It would help provide a framework for the product managers or credit risk managers to think about how a risk or marketing strategy impacts the revenue or expenses and hence the overall profits.
Profit, in general, is defined as the difference between revenue and expenses. Let’s start with the revenue drivers of the credit card business.
Profit = Revenue — Expense — Loss
Revenue Sources for a Card Issuer or an Issuing Bank:-
Interchange Fees: Merchant discount is paid by the merchant for facilitating the credit card transaction. It gets distributed among Acquiring Bank (Acquirer fees), Issuing Bank (Interchange Fees), and Payment Network (Network Fee). The portion of MDR that is accrued by the issuer bank is called “interchange,” and it usually ranges between 1% to 3% of the transaction, and it varies by payment networks and the value of transactions.
The Acquirer Bank (ICICI Bank in this example) pays the Merchant (Shopper’s stop) the entire transaction amount of Rs.1500 after deducting Merchant Discount Fees. The Issuer Bank (HDFC Bank) pays the Acquirer Bank (ICICI Bank) after taking the Interchange Fees. Both the Acquirer and the Issuing Bank pay the Payment Network (MasterCard) a Network fee.
Interest Income: The interest income is earned from card users who do not pay their bills in full. The unpaid credit card balance incurs an interest income for the card-issuing bank at rates varying roughly from 1.75% to 4% per month.
Annual Fees: Some credit cards charge an annual fee from the cardholders.
Foreign Transaction Charges: When a cardholder makes a purchase in the foreign country’s currency, their account is levied with a foreign currency conversion charge.
Cash Advance Fees: When issuers use their credit cards to get cash from their ATM then the customers are charged fees ranging from 2% to 3% of the amount of cash taken out.
Late Payment Fees: When a cardholder doesn’t pay the minimum due amount the customer needs to pay the Late Payment Fee.
Balance Transfer Fees: When a cardholder transfers credit outstanding from one credit card to another to get a lower interest rate then a fee of 3% to 5% of the transferred amount is levied.
Expenses of a Card Issuing Bank:-
In the credit card business, cost of capital, Acquisition or marketing costs, reward program costs, dispute management, fraud loss, branch costs, operations costs, and collection costs are the expenses incurred by the card-issuing bank.
Cost of Capital: Banks generally borrow money from Central banks or other financial institutions at an interest rate lower than the interest it charges it’s credit card customer.
Acquisition or Marketing Cost- There is a cost incurred by the card-issuing company to acquire a new set of customers. These expenses vary by the acquisition channels. The digital channel includes Google Adsense, Credit Card Broker, Credit Karma, and Bankrate, and the offline channels include mailing the offers to the customers at their residence. Usually, the cost of acquiring the customers via an offline channel is more.
Reward Program Cost- Banks give incentives to their customers for using credit cards. These rewards include points for frequent fliers, cash-backs, and discounts. However, the expense of these reward point redemption is bored by the card-issuing company.
Operating Costs- The cost of running the credit card portfolio are the cost of mailing statements, the cost of issuing the cards, the cost of using computers, and maintaining information.
The loss incurred by a Card Issuing Bank:- Some customers default on the minimum due payment by the end of each billing cycle. If the payment by the customer is late by 180 days, then the account is charged off. The credit and interest outstanding of the chargeoff customers are considered a loss in the bank’s balance sheet.
Credit card companies make money from interest and annual fees paid by the cardholder. Besides, the interchange paid by the merchant accepting credit cards is also the source of revenue for the credit card company. We also need to understand that the customer payment behavior impacts the kind of revenue the card issuer will realize. In the Credit Card Industry, there are transactors and Revolvers. Transactors are customers who pay the entire balance by the end of the billing cycle and hence drive up the non-interest income ( Interchange Income)while revolvers carry balances and hence drive up the interest income from these customers.
The expenses that are incurred by the credit card companies are the cost of capital, acquisition costs, branch costs, reward costs, dispute management costs, and collection costs. In addition, credit card companies also incur principal, interest, fees loss in case customers default on their minimum due payment, and thereby driving their profits down. The Expenses are impacted by the channel through which the customer is acquired — online vs in-branch acquisition. The credit score of the customer also drives the expenses because applications with a good credit score can be approved automatically which is less expensive vis-a-vis credit underwriter. In addition, it also results in lower collection expense and credit loss due to less charge offs by the customers with a good credit score.