The Credit Card Issuer (The Bank) And Associated Costs

Summary: Banks which offer credit card services have overall remained very profitable; however the risk is very high, because the credit card business is all about giving unsecured (uncollateralized) loans. The bank is dependant on the borrower not to default in large numbers. Banks incur several costs, some of which are given below: 1. Interest Expenses: Banks generally borrow the money from other forms at very low interest rates from other firms. They borrow the amount the custom...

Banks which offer credit card services have overall remained very profitable; however the risk is very high, because the credit card business is all about giving unsecured (uncollateralized) loans. The bank is dependant on the borrower not to default in large numbers. Banks incur several costs, some of which are given below: 1. Interest Expenses: Banks generally borrow the money from other forms at very low interest rates from other firms. They borrow the amount the customer requires, and lend this money to the customer at high interest rates. For example, if the card issuer charges 15% on money lent to customers, and it costs 5% to borrow the money to lend, and the balance sits with the cardholder for a year, the issuer earns 10% on the loan. This 5% difference is the "interest expense" and the 10% is the "net interest margin". Normally, if the customer pays back the entire amount borrowed on credit within the first billing period, no interest is charged. This depends upon different bank policies. 2. Charge Offs: Some customers simply never pay their credit card bill. A considerable amount of money which banks loan on credit to customers will never be repaid, and this has been accounted to over 20% of the total. This is a loss to the bank, and they repay have to pay for the loans. 3. Rewards: The more a customer uses their credit card, the more rewards he gets, such as frequent flier rewards, gift certificates, and other incentives. However, the more the incentive given to the customer, the more the bank has to pay for these incentives. However, most rewards points are accrued as a liability on a company's balance sheet and expensed at the time of reward redemption. Thus, the bank increases its cost associated with credit cards, and has to make sure a balance strike between customer satisfaction, and bank expenses. 4. Fraud: When a card is stolen, or an un-authorized duplicate made, the bank pays back the card holder (i.e. refunds money) for some or all of the things which the customer has been billed for, but did not buy. These refunds will be at the expense of the merchant, however are usually at the expense of the bank. Thus, any misuse of credit cards increases the expense of the bank. Statistics show that the cost of fraud is high, in 2004: it was over 500 million pounds in UK. 5. Operating Costs: There is of course the cost of running the credit card portfolio, i.e. the cost of printing the plastic, mailing statements and bills, the cost of using computers and maintaining information in order, as well as the marketing costs. Thus it shows that maintaining a credit card system for the card issuers is expensive, and banks must be careful when they invest into this line of service. A careful balance must be struck between the costs, and the revenue generated from the credit card users.