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