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Consumers rely on credit cards that
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cover their spending on a variety of
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fronts, but they also know that there
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are fees associated with those cards and
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for the most part they are going to be
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fairly high. Still, many wonder why the
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rates we pay on credit cards are so
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high. To better understand that, you
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have to know the basics of so-called
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credit card banking. And that was the
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subject of a paper earlier this year led
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by our guest today, Inamar Dressler, who
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is a professor of finance at the Wharton
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School and co-director of the Rodney El
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White Center for Financial Research.
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Inar, great to talk to you again. How
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are you, sir?
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>> Good. Thank you very much for having me
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on.
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>> Thank you. Uh, obviously this is a topic
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that a lot of people know about. It's in
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our day daily lives, but what was it
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that drew you to want to look at why
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these fees are so high? Uh actually my
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um co-authors who are uh also my
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students well two two of them are one of
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them is a former student who's a
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professor at Colombia now uh they came a
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couple years ago they wanted to talk
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about fintech because everybody talks
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about fintech and then we as we were
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thinking about why fintech may or may
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not be able to succeed in the
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marketplace. The question was what about
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the incumbents? And for a lot of these
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fintech kind of things, the incumbents,
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you know, in terms of getting people to
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borrow or spend with some kind of
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payment or borrowing technology, then
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the incumbent are credit cards. And we
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were like, okay, so what potential
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advantage or disadvantage do fintech
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have relative to the incumbents? And so
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we were trying to understand what's the
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economics of credit card banking. And
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one of the first things you see is okay,
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what kind of rates do credit cards
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charge? Uh, and they're extremely high.
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Uh, I don't borrow off my credit card,
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so I was less familiar with that. You
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look at them and they're just so much
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higher than any kind of um return that
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banks make on any other kind of loan or
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indeed any kind of other asset in the
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market. And so we're just interested in
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understanding like how do you get, you
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know, there is competition among credit
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card companies. How do you get to this
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kind of rate,
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>> right? And there obviously are are a
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variety of reasons for this and you go
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through a lot of in the paper. One of
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which uh I is how these companies market
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themselves and those marketing costs
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which have to be factored back into the
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overall uh fees that people pay.
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>> Yeah, that's something people have been
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uh particularly interested about in the
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paper, I guess, because it's the thing
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that you don't expect or don't think of.
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I maybe people do expect it, but I I
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didn't expect it. So when you think
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about it, you know, the kind of more
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obvious things are that significant, not
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huge, but a sign, you know, substantial
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default on credit cards, especially for
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lower credit scores. So you expect that,
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but that is nowhere near the rate that
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credit card companies charge. So the
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average credit card APR is right now is
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23 24%.
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5%, let's say, is just the short-term
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interest rate that the Fed sets. about
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uh 6%
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is is or 5% is uh sort of the average
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level of defaults. But that still leaves
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you know if that adds up to let's say 10
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11% that still leaves another 13% that
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is not explained by either of those kind
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of obvious things. And what we saw is
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that uh not the rest not the whole rest
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of it but about a little under half uh
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in a substantial amount is explained by
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these guys operating costs. Now, maybe
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I'm not very imaginative, but I never
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thought that credit card was
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particularly high operating cost kind of
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a business. But it turns out relative to
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all kinds of other banking, it is
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apparently extremely high. But one big
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piece of that is marketing. And it turns
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out that perhaps because a bunch of the
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credit card banks are not heavy on
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branches or physical locations or things
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like that, um they spend a lot on
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customer acquisition costs as pure
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marketing. And I was surprised to see
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literally how much they they spent. Um
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operating costs are, you know, about 5%
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of assets, meaning that for every dollar
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people borrow off a credit card, five%
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of that, 5 cents of that uh that they're
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paying in terms of their rate a year is
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just going to cover uh uh operating
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costs. And and like I said, a big part
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of that is is these customer acquisition
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costs. And it turns out that credit card
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banks are among the largest marketers
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that we see in the economy for
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consumers.
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>> I also found it interesting, you know,
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in the paper that the rewards programs
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that most of these credit card companies
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have, those are elements that are
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factored in as well.
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>> Yes. So the people are very into
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rewards. So rewards are very large. If
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you look at the amount of dollars that
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uh is paid out as rewards, it's it's
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really big. Uh I mean it's it's around
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depends how you you judge you know how
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you look at it exactly but just the the
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few largest credit card banks which are
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the most you know paid over $70 billion
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of credit card rewards. However, I
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should say I think there's a
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misconception that this somehow explains
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the high rates on credit cards and
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that's not true. The way that they pay
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that off is through the interchange. So
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that there's there's been some news
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reporting this week about a 20-year-old
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court case that was set on this.
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Interchange is is the fees that
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retailers pay whenever you swipe your
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credit card there. And maybe I don't
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know how much people know about this,
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but they charge on average over 2% of
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what you're paying. They have to to pay
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to the combination of the the card
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network like Visa and most of it goes to
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the issuing bank and most of that goes
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to people's rewards. So it's it's
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essentially a pass through and a lot of
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dollars that get charged as interchange.
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I think retailers as this court case
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showed really hate that but they have
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not been able to get around it.
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>> You mentioned as well that just the kind
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of the market power that these firms
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have as well.
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>> Yes. So I think a lot of this market by
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market power you know to be technical
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about it mean their ability to charge a
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rate that is higher than sort of the
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marginal cost of providing the dollar of
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loans. So it's not just the average
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defaults, the interest rate, the it it
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is above that. There is a markup above
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the cost of providing a dollar, but that
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markup
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>> in large part goes to paying things like
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the customer acquisition cost. So it
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it's still the case that it's a markup.
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It's still the case that if they did not
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spend so much on customer acquisition
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marketing, credit card rates would be
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several percentage points, maybe more
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than several lower. But the reason that
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that happens is because people respond
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to marketing. Uh it works. So, you know,
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I've talked to people about this. I
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think the best way to explain it is you
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could there could be an alternative
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credit card bank that would say, you
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know what, we're not going to do any of
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this marketing. We're going to save the
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money. We're going to charge people,
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let's say, 3 4% less on their credit
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card a year. And people are going to
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like that. They care about lower rates
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and they're going to come and they're
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going to uh take this credit card. That
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doesn't really work. People would not
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know about it and they would not respond
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to it. So such cards exist. If you
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really want to, you can go to credit
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unions that have much lower rates, but
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you know, we can see their market share
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is is is minuscule.
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>> Yeah. So what is then kind of the the
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best future outcome for the consumer in
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still being able to have the ability to
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use credit to to their advantage when
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they need to, but maybe a path where
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you're not paying the higher rates, you
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know, as we look down the road. Is
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fintech going to be something that is
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going to really delve into this in the
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years ahead?
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>> So, I think for people right now there
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that the the better options if they care
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about this kind of thing, they're
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willing to uh go to the not big trouble
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but small trouble of doing that is to to
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actually search. And so, for example, go
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to one of the credit unions uh that have
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this lower rate. There are also some
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banks. And another thing, which I
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actually really don't understand it
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completely, but I think it has to do
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with the fact that they spend way less
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uh marketing dollars on it, is that the
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same banks offer um uh uh personal loans
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that are bigger than the amount of
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credit you could get off a credit card
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and have a lower rate. So, and actually
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the people who use that, so it's not
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like nobody uses that, often use it to
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pay off their credit card debt. as far
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as I can tell. I mean, I I shouldn't I
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don't want to be seen as giving
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financial advice to people, but that is
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a superior, you know, exchange. You can
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get a bigger loan. You just have to
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control yourself from spending it. Pay
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off all your credit card debt and
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replace it. It's, you know, credit card
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consolidation as they call it and and
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and pay what is often a substantially
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lower rate. And this as available from,
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you know, MX, Discover,
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uh uh you know, Chase, they have that.
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Um it's it's strange, but it's true. And
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it's part of it is they don't they don't
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market it. So they're not trying to pay
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to get back the the the marketing
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dollars from the higher rate there. So I
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think that's clearly a superior trade
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for people as far as I could tell.
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>> Edomar, great to talk to you today.
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Thanks very much for your time.
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>> Thank you very much.
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>> Thank you, Edmar Drestler who is a
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professor of finance here at the Wharton
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School.
