Know your credit history

Bankcard burst onto the scene with a different, more mass, target audience. This audience typically used the new plastic card largely as a payment vehicle when cash flow issues precluded the use of cash or cheques. 

"Interest rates on credit cards have historically not moved in line with reductions in the cash rate.”

That meant the early days for credit cards saw relatively limited transaction volumes for a broad range of retail applications.

But the following two decades witnessed a profound change in positioning and use. Credit cards shifted from lending of last resort to a mainstream payment product with an optional line of credit.

Retail spend grew as more and more merchant segments allowed card payments such as bill payment, medical, supermarkets, education and on-line sales with a resultant boom in volumes.

Cards began to replace cash and cheques as a legitimate and indeed preferred means of payment. The result has been an enormous growth in the average number of annual purchases per account.

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The increasingly frequent use of credit cards illustrates one of the key features that differentiates this product from other personal loans such as mortgages and fixed term loans: not only do credit cards typically get used almost 15 times a month, they offer unsecured lending and provide a detailed monthly statement of use.

These characteristics drive a cost model that is fundamentally and increasingly different from other personal loans - and that means the role of funding costs in the business model is very different.

In the 1990s, another element was added to credit cards: loyalty or reward programs. These are sometimes seen as the sole driver of the growth in use of credit cards but that ignores other characteristics valued by cardholders.

These include:

• An interest free period that allows deferred payment terms
• A revolving line of credit when extended terms are required
• Around the clock and around the world access to digital payment capability
• The security enabled by a reduced need to carry cash
• A detailed monthly record of transactions
• Chargeback rights when goods & services are not provided
• On some cards, additional features such as travel insurance and concierge services

Reward schemes do offer an additional incentive to cardholders who routinely pay their monthly balance in full but this benefit sits alongside the underlying convenience, security and utility the data show us credit card users value.

Interest

One of the perennially controversial elements of the credit card business is interest rates. The rate charged on credit cards has historically not moved in line with reductions in the official central bank cash rate.

This is essentially due to the much smaller role played by the funding cost in the credit card model as compared with, for example, a home mortgage.

While funding costs are a factor, the increasing frequency of use of credit cards makes other revenue streams increasingly significant, further loosening the nexus with the funding cost.

The more prudent manner in which cardholders are managing their card debt is also changing the product economics. The reduction in the share of card balances on which interest is being paid means that for an increasing number of cardholders, the interest rate is actually purely academic; it is literally of no interest.

The Reserve Bank of Australia (RBA) publishes data on balances and balances accruing interest. The share of total balances accruing interest is called the “revolve” rate. Over the last 10 years, this rate has reduced by a considerable amount:

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Ten years ago, the proportion of credit card balances on which cardholders were not paying any interest was 27.6 per cent. That has today increased to 38.2 per cent - meaning card issuers are required to fund a considerably larger share of card spend because fewer people are paying interest.

Credit cards facilitated the growth of e-commerce by providing a convenient payment capability that could be used for online purchases. RBA data shows almost 1 in 5 purchases made with a credit card today are undertaken where the card is not present at the device.

However, while providing utility for the cardholder and a means of payment for the merchant, these card-not-present transactions have a much larger fraud cost. In 2013, the cost of this fraud was $A210.4 million. The most recent, 2018 data available from Australian Payments show the cost to the industry had increased to $A487.5 million.

When Bankcard was introduced, it was a case of one size fits all. Regardless of the user profile, there was no product differentiation.

Consumers today can choose from many products, ranging from fully optioned cards with a reward program, to basic function low rate/low fee cards, according to their lifestyle needs, product use and financial profile.

For users to choose the optimal card they need to consider the anticipated annual spend on the card, the expected ability and desire to pay the monthly balance in full, and the desire or otherwise to participate in any value-add features.

Unlike 1974, cardholders today who expect they will routinely or sometimes pay interest can select a low rate card.

Many years ago I was involved in research into consumers using a card without a free day period. That is, by definition, they paid interest. Yet many in this group claimed they paid no interest. Some would claim they lacked the expertise to make a sound decision.

But an alternative view was that unlike a mortgage with a typically large outstanding balance, this group considered the benefits offered by a card with a comparatively small balance to be more than sufficient to offset what they deemed to be a small monthly payment.

Australian consumers are, by and large, a well informed and savvy group. The shift in payment behaviour is evidence of their capacity to understand the pros and cons of competing products. Payments are no exception.

The changes in competing payment products have been huge. Consider:

• 10 years ago, the value of cheques was 5 times the value of payment cards. Cards are now double the value of customer cheques.
• 15 years ago, the number of purchases on credit and debit were about the same. Today, there are 2.4 debit purchase transactions for each purchase with a credit card.
• In 2007, about 69 per cent of consumer payments were in cash; by 2017 that had dropped to 37 per cent.
• The BNPL segment did not exist 5 years ago, with the market leader now claiming 3.5 million users.

To some extent, these changes have been driven by cost but also by the individual product attributes. Credit cards became established as an attractive and viable option to cash and cheques but as new products emerged and consumer preferences altered, the payments mix has continued to evolve.

When the cost and facility of credit cards is broken down, it is apparent official interest rates are not a major factor - the interest rate charged carries a risk premium for unsecured credit and the cost of funding interest-free periods and rewards schemes.

Were interest rates too high for that facility, we would expect consumers to move away. Perhaps we are starting to see that: while credit card use is still growing, it has a declining share of the total payments market. However, that too is not a simple matter. Just like when Bankcard entered the world in 1974, new entrants are coming into the market, disrupting the market - like real time payments - and there are regulatory impacts as well, changing the components of the business model.

Mike Ebstein is Founder & Principal at MWE Consulting